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Valuation of Common Stocks

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The Digital Growth Corp. Pays no cash dividends currently and is not expected to for the next 5 years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 5 years is 20% per year, and during this time it is expected to continue to reinvest all of its earnings. Afterward, the firm's ROE on new investments is expected to fall to 15%, and the company is expected to start paying out 40% of its earnings in cash dividends, which it will continue to do forever after. DG's market capitalization rate is 15% per year.

a. What is your estimate of DG's intrinsic value per share?
b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? The year after?
c. What effect would if have on your estimate of DG's intrinsic value if you expected DG to pay out only 20% of earnings?

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SOLUTION:

a. What is your estimate of DG's intrinsic value per share?

P5 = D6/(k - g) = 10.849/(.15-.09) = ...

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