Equity valuation

(1) Alpha Corp. pays dividends that are expected to grow at 5% each year. These will stop
in year 5, at which point the company will pay out all its earnings as dividends. Next
year’s dividend is $15 and its EPS at that time will be $20. If the appropriate discount
rate on Alpha shares is 10%, calculate the share price today.

r 0.1
g 0.05
1 2 3 4 5
DPS 15.00 15.75 16.54 17.36 18.23
EPS 20.00 21.00 22.05 23.15 24.31
1.10 1.21 1.33 1.46 1.61
13.64 13.02 12.42 11.86 11.32
P(1-5) 62.26
P(6 forever) 150.95
P 213.21

(2) The ROE of Alpha Inc. is 14% and the payout ratio is 0.5. The current book value per
share is Eur 50 and it will grow as the firm reinvests earnings. Assume that the ROE
and the payout ratio remain constant for the next 4 years. After that, the ROE will
decrease to 11.5% and the payout ratio will increase to 0.8. The appropriate discount
rate is 11.5%.
a) What are Alpha’s EPS and DPS next year?
b) How will EPS and DPS grow in years 2,3,4 5 and subsequent years?
c) What is Alpha’s share price?

g = b*ROE = 0.14*0.5 = 7%
EPS0 = Book value of equity*ROE= 50*0.14 = 7- DPS0 = EPS*payout=7*0.5= 3.5
a) EPS1 = 7*1.07 = 7.49- DPS1 = 3.745
b) EPS2 = 7*1.07^2 = 8.01 DPS2 = 4.005
EPS3 = 7*1.07^3 = 8.57 - DPS3 = 4.29
EPS4 = 7*1.07^4 = 9.17 - DPS4 = 4.59
P (1-4) = sum[t=1:4]DPSt/(1+r)^t
c) g2 (5-forever) = (1-d2)*ROE2= 0.2* 0.115 = 2.3%
P4= (DPS5/(r-g2))/(1+r)^4=(4.59*(1+0.023)/(0.115-0.023))/(1.115^4) = …..
P= P (1-4)+PV(P4)
 (3) ABC reported earnings of $102million for the last fiscal year and paid out 25% of
earnings as dividends and retained the 75% to finance it projects. The company is
expected to mantain this payout ratio in the future.
The company has 2 million shares outstanding and the current share price is $250. The return
on equity (ROE) is 12%. What is the required rate of return on the equity (r)?

EPS=102mln/2mln = 51; payout = 25%; b=75%

DPS = EPS*payout = 51*0.25= 12.75
g= 0.75* 0.12 = 9%
r= DIV/P +g =12.75/250 + 0.09 = 14.1%