Question

Summit Systems has an equity cost of capital of 11.5 %?, will pay a dividend of...

Summit Systems has an equity cost of capital of 11.5 %?, will pay a dividend of ?$1.75 in one? year, and its dividends had been expected to grow by 6.5 % per year. You read in the paper that Summit Systems has revised its growth prospects and now expects its dividends to grow at a rate of 3.5 % per year forever. a. What is the drop in value of a share of Summit Systems stock based on this? information? b. If you tried to sell your Summit Systems stock after reading this? news, what price would you be likely to? get? Why? a. What is the drop in value of a share of Summit Systems stock based on this? information? The drop in value of a share of Summit Systems stock is ?$ nothing. ?(Round to the nearest? cent.)

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Answer #1

a) Share price is computed as follows -

P0 = D1 / (Ke - g)

where, P0 = share price, D1 = expected dividend, Ke = cost of capital, g = growth rate

Price of share before the news

P0 = $1.75 / (0.115 - 0.065) = $35

Price of share after the news

P0 = $1.75 / (0.115 - 0.035) = $21.875

Drop in value = $35 - $21.875 = $13.125 or $13.13

b) After reading the news, you will likely be getting a price of $21.875 or $21.88 as the markets are efficient and will show the effect of this news immediately.

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