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Takeover target is run by entrenched management that insists on reinvesting 60% of its earnings in projects that provide a ROE of 10%, despite the fact that the firm’s capitalization rate is r=15%. The firm’s year-end dividend will be $2 per share, paid out of earning of $5 per share. At what price will the stock sell? What is the present value of growth opportunities (PVGO)? Why such a firm be a takeover target for another firm?

Respuesta :

Tundexi

Answer:

Growth = ROE * Retention ratio

Growth = 10% * 60%

Growth = 6%

Price of Stock = Dividend / (Capitalization Rate - Growth)

Price of Stock = 2/(15%-6%)

Price of Stock = 2 / 0.09

Price of Stock = 22.22

The stock will sell at per $22.22

PVGO = Stock Price - Earnings per share / Cost of Equity

PVGO = 22.22 - 5 / 15%

PVGO = 22.22 - 5 / 0.15

PVGO = 22.22 - 33.33

PVGO = -$11.11

Conclusion: Since Present Value of Growth Opportunities (PVGO) is negative, the ROE will decrease and share price will fall. So the investor can takeover the firm at lower price in future .

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