The stock of Nogro Corporation is currently selling for $16 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $16 per share. Earnings per share in the coming year are expected to be $4. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 25% rate of return per year. This situation is expected to continue indefinitely.

a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require? (Do not round intermediate calculations.) Rate of return %

b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested? PVGO $

Explanation / Answer

Answer:a Nogro Corporation:

D 1 = E 1 × (1– b ) = $4 × 0.5 = $2.00

g = b × ROE

= 0.5 × 0.25 = 0.125 or 12.5%

Therefore:

K=(D1/Po)+g

=(2/16)+0.125

=25%

Answer:b Since k = ROE, the NPV of future investment opportunities is zero:

PVGO=Po-E1/K

=$16-$4/0.25

=0

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