Question

Problem 4 - show your work.

The stock of Cacique Corp., is expected to have earnings per share (EPS) next year of $6 per share. The required return for its stock is 15%.

(a)What is the price of the stock if Cacique retains 50% of its earnings to finance future growth and these funds are invested in projects with a return on equity of 15 percent?

Assume that right now Cacique has more projects and it has to retain 70% instead of 50%. What is the price of the stock now if the return on equity is still 15 percent?

(b)Assume right now that Cacique C.A. can earn 18% (ROE=18%) on its investments. What is the price if the retention ratio is 50%? What is the price if Cacique retains 70%?

(c) Can you explain the difference obtained in the results of (a) and (b)?

Answer 1

Price=Expected EPS*(1-retention rate)/(required return-RoE*retention rate)

1.

=6*(1-50%)/(15%-15%*50%)

=40

2.

=6*(1-70%)/(15%-18%*70%)

=75

3.

Reinvestment at rate higher than required return increases share price as retention rate increases