Assume that Botswana Life Insurance (BOTS LIFE) pays no cash dividends currently and is not expected to for the next 5 years. Its latest EPS was $10, all of which was reinvested in the company. The firm’s expected ROE for the next 5 years is 20% per year, and during this time, it is expected to continue to reinvest all of its earnings. Starting 6 years from now the firm’s ROE on new investment is expected to fall to 15% and the company is expected to start paying out 40% of its earning in cash dividends, which it will continue to do forever after. BOTS LIFE’s market capitalisation rate is 15% per year.
(a) Estimate the intrinsic value per share of the firm [7 Marks]
(b) Assuming its current market price is equal to its intrinsic value, using illustrations, what do you expect to happen to its price over the next year and the year after? [5 Marks]
(c) Illustrate, what effect would it have on your estimate of the intrinsic value if BOTS LIFE is expected to pay out only 20% of earnings starting in year 6? [5 Marks
