Question

You expect that IBM will have earnings per share of $2.50 for the coming year. IBM...

You expect that IBM will have earnings per share of $2.50 for the coming year. IBM plans to retain all of its earnings for years 1-3. For the subsequent two years (years 4 and 5), the firm plans on retaining 40% of its earnings. It will then retain only 10% of its earnings from that point forward. Retained earnings will be invested in projects with an expected return of 15% per year. If IBM's equity cost of capital is 12%, then what is the the price of a share of IBM's stock?

Homework Answers

Answer #1
Calculation of the price of a share of IBM's stock
Price of a share of IBM's stock = Sum of Present values of all future dividends discounted at cost of capital i.e.12%
Year Dividend Discount Factor @ 12% Present Value
1 $0.00 0.892857 $0.00
2 $0.00 0.797194 $0.00
3 $0.00 0.71178 $0.00
4 $1.50 0.635518 $0.95
5 $1.50 0.567427 $0.85
Pertual (see working) $12.50 0.567427 $7.09
Price of a share of IBM's stock $8.90
Working
Per Year Dividend from 3rd Year onwards = Earnings per share x (1 - retention %) = $2.5 x (1 - 0.40) = $1.50
Value of perpetual dividend = Dividend payable / equity cost of capital = $1.5 / 12% = $12.50
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