Answer to Question #263407 in Finance for Marcus

Question

Assume today is 31 December 2021. Firm A, a commodity producer, is expected to adopt the following payout policy for the next 4 years: 

Year

 2022

2023

2024

2025

Dividends

($’ m)

9

12

5

0

 

The estimated net profit after tax is $50 million for the year 2025. The company has no preference share financing, and does not plan to do so for the next 4 years. The expected price-earnings ratio by the end of year 2025 is 15 times. Shareholders of Firm A require a return of 10 percent for shares in this risk class.

Required

a. Compute the intrinsic value of Firm A’s common shares.

 b. Critically evaluate the use of the Dividend Discount Model in valuing the shares of Firm A, and explain which alternative methods may be more appropriate

Answer 1

Intrinsic Value on (2025) = PE ratio*Net Profit after tax

=15*50 Million

=750 Million

Intrinsic Value of firm is present value of its future cash flow, discounted at the required return

Hence Intrinsic Value $= 9/1.1+12/1.1^2+5/1.1^3+750/1.1^4$

= $534.12 Million