Growth Opportunities
Takeover Target is run by entrenched management that insists on reinvesting 60% of its earnings in projects that provide an ROE of 10%, despite the fact that the firm’s capitalization rate is k = 15%. The firm’s year end dividend will be $2 per share, paid out of earnings of $5 per share. At what price will the stock sell? What is the present value of growth opportunities? Why would such a firm be a takeover target for another firm? Given current management’s investment policy, the dividend growth rate will be
g = ROE x b =10% x0.6 = 6% and the stock price should be P0 = $2/0.15 0.06 =$22.22 The present value of growth opportunities is PVGO = Price per share No growth value per share = $22.22 E1/k =$22.22 $5/0.15= $11.11 PVGO is negative. This is because the net present value of the firm’s projects is negative: The rate of return on those assets is less than the opportunity cost of capital. Such a firm would be subject to takeover, because another firm could buy the firm for the market price of $22.22 per share and increase the value of the firm by changing its investment policy. For example, if the new management simply paid out all earnings as dividends, the value of the firm would increase to its no growth value, E1/k =$5/0.15 = $33.33.