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03rec3 Exercise

This document contains recitation notes summarizing key concepts in finance: 1) It provides the solution to valuing Company XYZ, which pays annual dividends that grow at 10% for 10 years and then 5% indefinitely, using a dividend discount model. The value is found to be $13.589. 2) It answers questions about MetaTrend Corps., which earns a 12% return on equity (ROE) and pays out half earnings as dividends, reinvesting the rest. Its growth rate is calculated as 6% and its share value at a 12% cost of capital is $10 based on a dividend discount model. 3) Changing to pay out all earnings as dividends does

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174 views2 pages

03rec3 Exercise

This document contains recitation notes summarizing key concepts in finance: 1) It provides the solution to valuing Company XYZ, which pays annual dividends that grow at 10% for 10 years and then 5% indefinitely, using a dividend discount model. The value is found to be $13.589. 2) It answers questions about MetaTrend Corps., which earns a 12% return on equity (ROE) and pays out half earnings as dividends, reinvesting the rest. Its growth rate is calculated as 6% and its share value at a 12% cost of capital is $10 based on a dividend discount model. 3) Changing to pay out all earnings as dividends does

Uploaded by

junaid1626
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We take content rights seriously. If you suspect this is your content, claim it here.
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MIT Sloan School of Management

J. Wang 15.407
E52-456 Fall 2003

Recitation Notes 10/2/2002


1. Company XYZ’s year-end dividend will be $1. It will grow at 10% for 10 years and
then slows down to 5% per year forever. The cost of capital for XYZ is 15%. What is
the price of company XYZ?
Answer:
We consider the second stage-growth first.
So in 10 years, the value of XYZ will be
1∗(1+10%)1 0
15%−5%
= $25.937
So the value today is:
1
15%
∗ [1 − ( 1+10%
1+15%
25.937
)1 0] + (1+15%) 1 0 = $13.589

2. MetaTrend Corps. earns a book rate of return (ROE) of 12%. It reinvests one-half its
earnings and pays out the other half as cash dividends. The nominal cost of capital is
12%.
(a) Given this ROE and dividend payout ratio, what is the growth rate of MetaTrend’s
earnings and dividends?
(b) Assume this growth rate is expected to continue in perpetuity. What is the present
value of MetaTrend shares? Assume that book value per share is $10.
(c) Suppose MetaTrend decideds to pay out all its earnings as cash dividends. There-
fore it does not grow. What is the change, if any, in MetaTrend’s stock price?
Why?
Answer:

(a) We can use the growth formula


growth = ROE × (1 − payout ratio)
= 0.12 × (1 − 0.5)
= 0.06

(b) We can apply the formula of DDM with constant growth


book value × ROE × payout ratio
PMetaTrend =
cost of capital - growth
10 × 0.12 × 0.5
=
0.12 − 0.06
= 10
(c) We can apply the formula of DDM with no growth

book value × ROE × payout ratio


PMetaTrend =
cost of capital
10 × 0.12
=
0.12
= 10

The price is same as that of part a. The reason is that the dividends gave up
exactly offset the present value of the increase of future cash flows, ie ROE =
cost of capital.

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