Faculty of Economics and Business
Department of Business
FINANCE I (102329) – Group 3 – 2012-13
Study Guide. Dr. Maria-Antonia Tarrazon & Dr. Joan Montllor
1
TOPIC 6. EXERCISE 6 : The company One-Never-Knows Inc.
SOLVED EXAMPLE
Concerning the stock exchange of the Three-Dimensional Kingdom and the company One-Never-
Knows Inc. following data are known:
- Expected earnings (profit) per share at the end of the current year: 50 €
- Payout ratio (1-b): 40%
- Coefficient beta of present investments (current firm’s situation): 0.9
- Coefficient beta of new investments: 1.2
- Expected return on new investments: 30%
- Book value per share: 178 €
- Stock price on the stock exchange: 289 €
- Risk-free interest rate: 3.5%
- Expected return on the market index: 22.5%
- Total risk of the market index: 20%
CALCULATION OF THE STOCK MARKET VALUE (OR FAIR PRICE):
Since the required rates of return on present and on new investments are different only the present
value of growth opportunities (PVGO) model can be applied.
Previous calculations:
Current situation of the firm:
Rreq.to firm = 0.035 + (0.225 – 0.035)·0.9 = 0.2060 Rreq.to firm = 20.6%
Expected earnings per share: 50€ dividends: 0.4·50€ = 20€
retained earnings: 0.6·50€ = 30€.
New investements:
Initial investment: a0 = 30€ (100% of retained profits)
Expected growth rate: g = 0.6·0.3 = 0.18 g = 18% (a very high rate!)
Rreq.to new investements = 0.035 + (0.225 – 0.035)·1.2 = 0.2630 Rreq. n.i = 26.30%
Since En.i. =30% > Rreq. n.i. =26.30% NPVn.i. > 0
Notice also that the growth rate g is compatible with the required rates of return on both present and
new investments since Rreq. > g in both cases.
Market value of one stock (PVOG model): (equations 26 to 28)
NPV of new investements:
22.430
2630.0
3.0·30
NPVn.i.
€ ( 28 )
