What is the Rate of Return Percentage?
In the mini-case, Mr. Breezeway indicated two kinds of percentage to determine the required return. One of them is the companies' return on book equity (% 15) and the other one is the investment return percentage in the rural supermarket industry (% 11) which shows that investors in rural supermarket chains, with risks similar to Prairie Home Stores, expected to earn about % 11 percent on average. Since the companies' rate of return determined by the rate of return offered by other equally risky stocks, then it should be % 11.
The Rapid Growth Scenario
Step 1: Being able to calculate the present value of the companies' stocks, we should first calculate the present value of the companies'…show more content… P0 = 16.17 $ + 257.33 ÷ (1.11)6 = 153.75 million $
Present Value of the Stock Per share = 153.75 million ÷ 400,000 (Outstanding shares) = 384.37 $
If the company did go public, its share price should be $384.37 for per share with the rapid growth scenario.
The Constant Growth Scenario:
Growth rate: plowback ratio × return on equity (Given in the notes)
Plowback ratio = Retained earnings ÷ Earnings (2016) = 4/12 = % 33
Return on equity = Earnings ÷ Book value, start of the year (2016) = 12 ÷ 80 = % 15
Growth rate = % 33 × % 15 = % 5
P0 = Div2016 ÷ r - g Per Share Value = 133.33 million ÷ 400,000 = 8 million ÷ 0.11 - 0.05 = 333.33 $ = 133.33 million
If the company did go public, its share price should be $333.33 for per share with the constant growth scenario.
If I were Ms. Firewater, I would recommend the rapid growth scenario because with the rapid growth scenario the companies' present per share value higher than it could have been with the constant rate scenario. In addition, this investment decision depends on shareholders' opinion. As we know, some of the shareholders are dependent on the generous regular dividends. As a result, these shareholders might have not wanted to choose the rapid grow scenario. On the other hand, the shareholders who have more interest