Question

Milton Glasses recently paid a dividend of $1.70 per share, is currently expected to grow at a constant rate of 5%, and has a required return of 11%. Milton Glasses has been approached to buy a new company. Milton estimates if it buys the company, its constant growth rate would increase to 6.5%, but the firm would also be riskier, therefore increasing the required return of the company to 12%. Should Milton go ahead with the purchase of the new company?

Answer 1

Milton Glasses should go ahead with the purchase of the new company.

Step-by-step explanation:

Milton Glasses is considering buying a new company that would increase its growth rate to 6.5% but also increase the required return to 12%. To determine whether or not Milton should proceed with the purchase, we need to compare the new required return with the expected return from the increased growth rate. The formula to calculate the expected return is the dividend divided by the required return minus the growth rate. In this case, the expected return with the new growth rate would be $1.70 / (0.12 - 0.065) = $34.

Since the expected return is higher than the price per share, it would be beneficial for Milton Glasses to go ahead with the purchase of the new company.

Answer 2

Milton should buy the company

Step-by-step explanation:

Comparing the intrinsic value of the company in both scenarios using the Gordon Growth Model we get:

PV = [D0 * (1 + g)] / (r - g) where

D0 is current dividend

g = growth rate

r = required rate of return

Case 1 = current

PV = 1.7 * (1 + 0.05) / (0.11 - 0.05)

PV = 29.75

Case 2 = buying company

PV = 1.7 * ( 1 + 0.065) / ( 0.12 - 0.065)

PV = 32.92

The present value of the share when buying the company is higher than the current present value, therefore Milton should go ahead buying the company.