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Financial Analysis of Encore
Question
Financial Analysis of Encore
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## Encore's Strategic Growth Plan and Financial Estimates

Question 1

a) Total book value of the firm in 2015 = \$ 60 million Number of ordinary shares outstanding in 2015 = 2.5 million Hence, book value per share = 60/2.5 = \$ 24

b) Price per ordinary share of the company as per the data provided = \$ 40 Earnings per share = \$ 6.25 Hence, firm’s current P/E = 40/6.25 = 6.4

c)(i) The required rate of return on Encore shares can be estimated using the expected premium that would be given so as to compensate investors for the incremental risk assumed.

It is known that the risk free rate is 6% pa Under the current situation, the share premium required is 8.8% pa Hence, the current required rate on Encore shares = 6 + 8.8 = 14.8% pa

(ii) Due to the expansion of the company in European and Latin American market, the underlying risk would increase and hence the overall risk premium on the stock increases to 10% pa. It is known that the risk free rate is 6% pa Hence, the current required rate on Encore shares = 6 + 10 = 16% pa

d) As per the securities analyst, the future growth in dividend till perpetuity is going to be zero. We deploy the Gordon dividend discount model to estimate the price of the stock.
Price of the stock = Next year dividend /(Expected return – Perpetual dividend growth rate)

Since, dividend growth rate is zero, hence next year dividend is the same as current year dividend i.e. \$ 4 per share. Hence, stock price = 4/(0.16-0) = \$ 25

e) Now, it is given that the expected growth rate of dividends perpetually is 6%, Hence, dividend per share next year = 4*1.06 = \$ 4.244 Price of the stock = Next year dividend /(Expected return – Perpetual dividend growth rate) Hence, stock price = 4.24/(0.16-0.06) = \$ 42.4

(2)  The current dividend is \$ 4 per share. Let us consider this year 0.

Dividend in year 1 = 4*1.08 = \$ 4.32

Dividend in year 2 = 4.32*1.08 = \$ 4.666

Dividend in year 3 = 4.666*1.06 = \$ 4.946

The required rate of return = 16% pa

Hence, stock price = 4.32/1.16 + 4.666/1.162 + 4.946/[(0.16-0.06)*1.162] = \$ 43.94

f) In the above parts, the share values have been estimated using the Gordon dividend discount model and thus estimate the intrinsic price or the actual price of the stock. However, the price given in the question is \$ 40 which is the market price which is not always equal to the intrinsic price since the markets are not efficient. Further, even theoretical prices keep on changing as per the various inputs as seen in the given question. For instance when the dividend growth rate is altered, the intrinsic price of the stock would change. Hence, by changing the theoretical inputs various different prices are being obtained.
The better pricing mechanism is the market price especially in a stable market as it allows for better price discovery. This is not possible in case of theoretical methods as the final answers are sensitive to changes in the input.