Question

XYZ Company has the following data:     1995           1996           Abnormal earnings       

XYZ Company has the following data:

    1995           1996          

Abnormal earnings       -$15            $10             

XYZ Company has a book value of $100 per share at the beginning of 1995 and its cost of capital is 8%. After 1996, abnormal earnings will grow by 5% per year.

The estimated stock price at the beginning of 1995 using the abnormal earnings model is

A.

$395
B.

$423
C.

$445
D.

$473
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Homework Answers

Answer #1

Estimated Stock Price using abnormal earnings model=Book Value+Future earnings discounted by cost of capital

=$100+ (-15/1.08) + 10/(1.08*1.08) + 10.5/(1.08*1.08*1.08) + 11.025/(1.08*1.08*1.08*1.08).......

Since after 1996, the earnings every year rises by 5%, while additional discounting by 8% Cost of capital will be done, we will use Geometrical Progession.

Sum of infinite terms of a GP series S∞= a/(1-r). If a is the first term, r is the common ratio. a=10/(1.08*1.08), r=1.05/1.08

Estimated Stock Price=$100+ (-15/1.08) + 10/(1.08*1.08) / (1-1.05/1.08)

=100-13.89 + 8.57/0.0278

=86.11+ 308.27

=394.38

=$395(approx, due to decimal numbers)

Option A is correct.

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