Assume an all equity 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 net of dividends 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 outstand¬ing)?

Question

Quizplus · Accepted Answer

The market value of the firm's common equity can be calculated using the Gordon Growth Model. First, calculate the required rate of return using the CAPM: Required return = Risk-free rate + Beta * Market risk premium = 8% + 1.25 * 4% = 13%. Next, calculate the dividends for the next three years and the terminal value at the end of year 3 using the growth rates provided. Finally, discount these cash flows back to the present value and divide by the number of shares to find the market value per share. The correct calculation leads to a market value of $9.18 million.

Assume an All Equity Firm Has Been Growing at a 15