You currently work for a firm that has investment capital per share equal to $100. This firm currently enjoys an annual return on capital of 12 percent. The cash flows generated by this capital occur at the end of the year (or the beginning of the next year) and are risky. In fact, the beta of the cash flow is .8. The expected excess return on the market (i.e., E(Rm) – Rf ) is 8 percent (i.e., E(Rm) - Rf = .08). The risk free rate is 4 percent (i.e., Rf = .04).
Your firm currently has a policy of paying all cash flows out as a dividend. That is, its payout ratio is 100 percent (or equivalently, the plowback ratio is zero).
Questions:
A. Given the current payout policy, what are the earnings per share for your firm?
B. What discount rate will the market apply to your cash flows if CAPM holds?
C. If you retain 50 percent of earnings each year (and pay out the other 50 percent as a dividend) and grow the company, what will the new value of your firm be?
D. Under the 50 percent plowback policy, what is the present value of growth opportunities for your firm? That is, what is the difference between the price under the 50 percent payout rule versus the no growth price (with a 100 percent payout rule)?