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    Calculating the market value of firm's common equity

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    Assume a firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firm's common equity (1 million shares outstanding)?

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    This year's retained earnings=$1.4 million
    Payout ratio=30%

    Retained earnings =Net earnings*(1-Payout ratio)
    Net earnings=Retained earnings/(1-payout ratio)=1.4/(1-30%)=2.0 million

    Dividend=Net earnings*payout ratio=2*30%=$0.6 million
    Number of shares outstanding = 1million
    Current Dividend per share=Do=$0.6 million/1 million=$0.6

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    Solution Summary

    The solution depicts the formulas and methodology to find the market value of firm's common equity in the given case. Market equilibrium is examined......