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FIN622 Corporate Finance GDB 2 Solution Fall 2012

Big Gee Limited (BGL) has reported earnings per share of Rs.15 with 0.70:1 payout for the year 2011. Its dividends have been growing at a constant rate of 8% and are expected to continue at the same for foreseeable future.

Mr. Young – a fresh business graduate has recently joined BGL as business analyst. On one day during his training, he was assigned a task to forecast BGL’s dividend growth rate and intrinsic value of the company’s stock for the next year using the famous Dividend Discount Model (DDM).

Based on the data given to him, Mr. Young estimated a growth rate of 12%. For an ordinarily prudent investor in the similar industry, Young estimated a required rate of return at 10%. On this basis, he estimated the intrinsic value – an unreal price surely.

While presenting his work to the other training mates, he could not defend his estimates as he has to face strong arguments about the unreal price. Mr. Old – a senior finance manager argued that the estimated growth rate by Young had resulted in the negative share price that is not acceptable in any case in the real world.

Required:

  1. Compute the share value as done by Mr.Young;                                       (1.0 Mark)
  2. Comment on this value; &                                                                         (0.5 Mark)
  3. Support your comments with logical reason.                                             (0.5 Mark)

Solution:

Stock Price = D1 / (r – g)

=15/(0.10-0.12)

=15/(-0.02)

=750

Mr. Young estimated a growth rate of 12% and Young estimated a required rate of return at 10%.

 

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