mini case solution

The keys to the company’s future value and growth are profitability (ROE) and the reinvestment of retained earnings. Retained earnings are determined by dividend payout. The spreadsheet sets ROE at 15% for the five years from 2006 to 2010. If Reeby Sports will lose its competitive edge by 2011, then it cannot continue earning more than its 10% cost of capital. Therefore ROE is reduced to 10% starting in 2011. The payout ratio is set at .30 from 2006 onwards. Notice that the long-term growth rate, which settles in between 2011 and 2012, is ROE × ( 1 – dividend payout ratio ) = .10 × (1 - .30) = .07. The spreadsheet allows you can vary ROE and the dividend payout ratio separately for 2006-2010 and for 2011-2012. But let’s start with the initial input values. To calculate share value, we have to estimate a horizon value at 2010 and add its PV to the PV of dividends from 2005 to 2010. Using the constant-growth DCF formula,

The PV of dividends from 2005 to 2010 is $3.43 in 2004, so share value in 2004 is: The spreadsheet also calculates the PV of dividends through 2012 and the horizon value at 2012. Notice that the PV in 2004 remains at $16.82. This makes sense, since the value of a firm should not depend on the investment horizon chosen for valuation. We have reduced ROE to the 10% cost of capital after 2010, assuming that the company will have exhausted valuable growth opportunities by that date. With PVGO = 0, PV = EPS/r. So we could discard the constant-growth DCF formula and just divide EPS in 2011 by the cost of capital: The keys to the company’s future value and growth are profitability (ROE) and the reinvestment of retained earnings. Retained earnings are determined by dividend payout. The spreadsheet sets ROE at 15% for the five years from 2006 to 2010. If Reeby Sports will lose its competitive edge by 2011, then it cannot continue earning more than its 10% cost of capital. Therefore ROE is reduced to 10% starting in 2011.