Question

NONCONSTANT GROWTH VALUATION Holt Enterprises recently paid a dividend, Do, of $2.25. It expects to have nonconstant growth of 16% for 2 years followed by a constant rate of 7% thereafter. The firm's required return is 11%. a. How far away is the horizon date? I. The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the end of Year 2. II. The terminal, or horizon, date is infinity since common stocks do not have a maturity date. III. The terminal, or horizon, date is Year 0 since the value of a common stock is the present value of all future expected dividends at time zero IV The terminal, or horizon, date is the date when the growth rate becomes nonconstant. This occurs at time zero. V. The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the beginning of Year 2 -Select b. What is the firm's horizon, or continuing, value? Round your answer to two decimal places. Do not round your intermediate calculations. c. What is the firm's intrinsic value today, Po? Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

Question 1: How far away is the horizon date?

Option 1: When the growth rate become constant at the end of year 2.

For the next two parts of the question, we need to use the two stage gordon growth model and/or two stage dividend discount model.

Intrinsic Value = Value in the growth stage + Horizon Value

We know that D₀ = $ 2.25

Let us also calculate the dividends at the end of 1st and 2d Year.

D₁ = D₀ * (1 + 16%) = 2.25 * (1+16%) = $ 2.61

D₂ = D₁ * (1 + 16%) = 2.61 * (1+16%) = $ 3.0276

Question 2: Firm's Horizon or Continuing Value

This can be calculated as:

Horizon Value = D₂ * (1+ g) / (r - g)

wherein, D₂ = Dividend in Year 2

g = Long Term Growth Rate = 7%

r = Required Return = 11%

Using the abovementioned values in the Horizon Value formula

Horizon Value = $ 3.0276 * ( 1 + 7%) / (11% - 7%)

Horizon Value = $ 3.239532 / 4%

Horizon Value = $ 80.9883 = $ 80.99 ..... (rounded to 2 decimal places)

Question 3: Intrinsic value

As stated above, the intrinsic value can be calculated using the 2 stage gordon growth model:

Intrinsic Value = Value in the growth stage + Horizon Value

Intrinsic Value = P_o = [ D₀ * (1+16%) / (1 + r) ] + [ D₁ * (1+16%) / (1 + r)^2 ] + [ Horizon Value / (1 + r)^2 ]

Here, in the above formula in the growth stage, the dividends are discounted by the required rate of return to present value and also, the horizon value at the end of year 2 is discounted to the present value

Intrinsic Value = P_o = [ D₁ / (1 + r) ] + [ D₂ / (1 + r)^2 ] + [ Horizon Value / (1 + r)^2 ]

Since, D₁ = D₀ * (1+16%) = $ 2.61 ...calculated above

D₂ = D₁ * (1+16%) = $ 3.0276 ...calculated above

r = 11% required rate of return ... given

Horizon Value = $ 80.9883 ...calculated above

Using these, in the formula for Intrinsic value:

Intrinsic Value = P_o = [ 2.61 / 1.11 ] + [ 3.0276 / 1.2321 ] + [80.9883 / 1.2321]

Intrinsic Value = P_o = $ 70.54054 = $ 70.54  ..... (rounded to 2 decimal places)