© 2012 McGrawHill Ryerson Ltd.Chapter 7 -1  The fraction of earnings retained by the firm is called the plowback ratio  The fraction of earnings a company.

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© 2012 McGrawHill Ryerson Ltd.Chapter 7 -1  The fraction of earnings retained by the firm is called the plowback ratio  The fraction of earnings a company pays out in dividends is called the payout ratio  Calculating “g” (growth rate) ◦ The growth rate for a company can be computed by multiplying the return on equity by the plowback ratio: g = ROE x plowback ratio LO4

© 2012 McGrawHill Ryerson Ltd.Chapter 7 -2  Example: Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20%.  Calculate the value of the stock before and after the plowback decision We have: D 1 = $5.00 r = 12% Return on equity = 20% LO4

© 2012 McGrawHill Ryerson Ltd.Chapter 7-3 Without the growth, the price is: With growth, the situation is: g = ROE x plowback ratio = 0.20 x 0.40 = 0.08 = 8% P 0 = DIV 1 /r = 5/0.12 = $41.67 P 0 = DIV 1 /(r – g) = 3/(0.12 – 0.08) = $75 LO4

© 2012 McGrawHill Ryerson Ltd.Chapter 7 -4  Thus, growth accounts for $33.33 [=$75-$41.67] of the $75 price. In other words, the Present Value of Growth Opportunities (PVGO) is $  The Present Value of Growth Opportunities (PVGO): The net present value of a firm’s future investments.  Sustainable Growth Rate: Steady rate at which a firm can grow: plowback ratio X return on equity.  Price-Earning Ratio: Stock price/EPS LO4

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