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29 April, 02:33

Milton Glasses recently paid a dividend of $1.70 per share, is currently expected to grow at a constant rate of 5%, and has a required return of 11%. Milton Glasses has been approached to buy a new company. Milton estimates if it buys the company, its constant growth rate would increase to 6.5%, but the firm would also be riskier, therefore increasing the required return of the company to 12%. Should Milton go ahead with the purchase of the new company?

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  1. 29 April, 05:45
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    Milton should buy the company

    Explanation:

    Comparing the intrinsic value of the company in both scenarios using the Gordon Growth Model we get:

    PV = [D0 * (1 + g) ] / (r - g) where

    D0 is current dividend

    g = growth rate

    r = required rate of return

    Case 1 = current

    PV = 1.7 * (1 + 0.05) / (0.11 - 0.05)

    PV = 29.75

    Case 2 = buying company

    PV = 1.7 * (1 + 0.065) / (0.12 - 0.065)

    PV = 32.92

    The present value of the share when buying the company is higher than the current present value, therefore Milton should go ahead buying the company.
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