You are trying to value Cederburg Tech. using the dividend discount model. Ceder

Question

You are trying to value Cederburg Tech. using the dividend discount model. Cederburg Tech is expected to pay $60 million in dividends on net income of $100 million next year. It is in stable growth, expecting to grow 4% a year in perpetuity. The cost of equity for the firm is 8%.

a) Value the equity in Cederburg Tech.

b) If the expected growth rate is correct as 4% a year, estimate the return on equity (ROE) that you are assuming for Cederburg Tech in perpetuity.

c) Assume now that you are told that Cederburg Tech can increase its return on equity (ROE) to 12% in perpetuity. If the expected growth rate remains unchanged as 4% a year, what would be the cost of equity have to be for equity value to remain unchanged (from your answer in (a)

Explanation / Answer

a)

D1 = 60, r =8%, g = 4%

Value = D1 / (r-g)

      = 60 / (8%-4%) = 1500

b)

retention rate = (100-60) / 100 = 0.4

ROE = growth rate / retention rate

         = 4% / 0.4 = 10%

c)

retention rate = growth rate / ROE

                  = 4% / 12% = 0.33

dividend = (1-0.33)*100 = 66.67 million

cost of equity = (dividend / value) + g

                    = (66.67/1500) + 4% = 8.44%

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