Question

You believe the Gordon (constant) growth model is appropriate to value the stock of Reliable Electric Corp. The company had an EPS of $2 in 2008 . The earnings in the next year without the additional planned investments are expected to remain at $2. The retention ratio is 0.60. The company is expected to earn an ROE of 14 percent on its investments and the required rate of return is 11 percent. Assume that all dividends are paid at the end of the year. A. Calculate the company's sustainable growth rate. The company's SGR = percent. (Enter your answer as a number with two decimal places but without the percent symbol. For example, if your answer is 89.1245%, enter 89.12) B. Estimate the value of the company's stock at the beginning of 2009. The value of the company's stock at the beginning of 2009 is dollars. (Round your final answer to two decimal places. Do not round intermediate computations. Do not enter the currency symbol. For example, if your answer is $89.1245, enter 89.12 ) C. Calculate the present value of growth opportunities (Reminder: This assumes that if the company was a no-growth company, the payout ratio would be 100%, the retention ratio would be zero percent, and its earnings would stay the same). PVGO = dollars (Round your final answer to two decimal places. Do not round intermediate computations. Do not enter the currency symbol. For example, if your answer is $89.1245, enter 89.12 ) D. Determine the fraction of the company's value which comes from its growth opportunities (i.e. compute PVGO/Value). The fraction of the company's value which comes from growth opportunities is percent. (Enter your answer as a number with two decimal places but without the percent symbol. For example, if your answer is 89.1245%, enter 89.12)

Answer 1

The sustainable growth rate is 8.40%. The value of the company's stock at the beginning of 2009 is $50 per share. The fraction of the company's value from growth opportunities is 56.36%.

Step-by-step explanation:

To calculate the sustainable growth rate (SGR), use the formula: SGR = ROE x retention ratio. In this case, the ROE is 14% and the retention ratio is 0.60.

Therefore, the SGR = 14% x 0.60 = 8.40%

To estimate the value of the company's stock at the beginning of 2009, use the Gordon growth model formula: Value = EPS / (required rate of return - SGR). The EPS is $2 and the required rate of return is 11%, while the SGR is 8.40%. Substituting the values, the value of the stock is $2 / (0.11 - 0.084) = $50 per share.

To calculate the present value of growth opportunities (PVGO), use the formula:

PVGO = Value - EPS / required rate of return.

Substituting the values, the PVGO = $50 - $2 / 0.11 = $28.18.

To determine the fraction of the company's value which comes from growth opportunities, divide the PVGO by the value of the company's stock: Fraction = PVGO / Value.

Substituting the values, the fraction of the company's value from growth opportunities is $28.18 / $50 = 0.5636 or 56.36%.