You are a research analyst for a major investment bank and have been asked to ev
ID: 2647815 • Letter: Y
Question
You are a research analyst for a major investment bank and have been asked to evaluate three candidates for a takeover and recommend one. You estimate the risk-free rate to be 5% and the market risk premium to be 8%. You also have the following data:
MTT Corp. NOR Corp. TECH Corp.
current price $20 $25 $200
number shares 100,000 80,000 10,000
current EPS $4 $2.50 $5
payout ratio 50% 20% 10%
(first 5 yrs)
beta 1.0 1.25 1.5
growth rate:
first 5 yrs. 5% 20% 50%
beyond 5 yrs. 5% 10% 10%
D/E ratio 0 0 0
ROA:
first 5 yrs. 10% 25% 55.56%
beyond 5 yrs. 10% 20% 25%
Which firm is the best candidate for a takeover? Clue calculate intrinsic value and overvaluation/undervaluation using relevant metrics like Gordon Shapiro model, constant dividend growth model etc.
Explanation / Answer
MTT Corp.
As per Gordon model
Required rate of return = Risk free return + market Risk premium*Beta
Required rate of return = 5 + 8*1
Required rate of return = 13%
As per constant dividend growth model
Intrinsic value = Expected Dividend/(Required rate of return - Growth Rate)
Intrinsic value = 4*50%*(1+5%)/(13%-5%)
Intrinsic value = $ 26.25
Undervaluation per Share = (26.25-20) = 6.25
NOR Corp.
As per Gordon model
Required rate of return = Risk free return + market Risk premium*Beta
Required rate of return = 5 + 8*1.25
Required rate of return = 15%
As per constant dividend growth model
D1 = 2.5*20% *1.2 = 0.60
D2 = 0.6*1.2
D3 = 0.6*1.2^2
D4 = 0.6*1.2^3
D5 = 0.6*1.2^4
D6 = 0.6*1.2^4*1.1
Intrinsic value = 0.60/1.15 + 0.6*1.2/1.15^2 + 0.6*1.2^2/1.15^3 + 0.6*1.2^3/1.15^4 + 0.6*1.2^4/1.15^5 + (0.6*1.2^4*1.1/(15%-10%))/1.15^5
Intrinsic value = $ 16.45
Tech Corp.
As per Gordon model
Required rate of return = Risk free return + market Risk premium*Beta
Required rate of return = 5 + 8*1.5
Required rate of return = 17%
As per constant dividend growth model
D1 = 5*10% *1.5 = 0.75
D2 = 0.75*1.5
D3 =0.75*1.5^2
D4 = 0.75*1.5^3
D5 = 0.75*1.5^4
D6 = 0.75*1.5^4*1.1
Intrinsic value = 0.75/1.17 + 0.75*1.5/1.17^2 + 0.75*1.5^2/1.17^3 + 0.75*1.5^3/1.17^4 + 0.75*1.5^4/1.17^5 + (0.75*1.5^4*1.1/(15%-10%))/1.17^5
Intrinsic value = $ 43.70
Overvaluation = (200-43.70) = 156.30
Decision
MTT Corp is the best candidate for a takeover as it is undervalued & other firm are overvalued
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