Question

Ace Ventura, Inc., has expected earnings of $5 per share for next year. The firm's ROE is 15%, and its earnings retention ratio is 40%. If the firm's market capitalization rate is 10%, to the nearest dollar what is the present value of its growth opportunities

Answer 1

Answer: $25

Step-by-step explanation:

Value with no growth = Expected earnings/Market capitalization rate

= $5/10%

= $5/0.1

= $50

Growth rate = Earnings retention ratio × ROE

Growth rate = 40% × 15%

= 40/100 × 15/100

= 0.4 × 0.15

= 0.06 = 6%

Value with growth = [$5 × (1-0.4)]/(0.10 - 0.06)

= ($5 × 0.6)/0.04

= $3/0.04

= $75

Present value of growth opportunities will now be:

= Value with growth - value with no growth

= $75 - $50

= $25