Question

Summit Systems has an equity cost of capital of

11.5 %,

will pay a dividend of

​$1.501.50

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

3.0 %

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?

Answer 1

Answer a.

If growth rate is 6.50%:

Value of share = Dividend in year 1 / (Cost of capital - Growth rate)
Value of share = $1.50 / (0.1150 - 0.0650)
Value of share = $1.50 / 0.05
Value of share = $30.00

If growth rate is 3.00%:

Value of share = Dividend in year 1 / (Cost of capital - Growth rate)
Value of share = $1.50 / (0.1150 - 0.0300)
Value of share = $1.50 / 0.0850
Value of share = $17.65

Drop in value of share = $30.00 - $17.65
Drop in value of share = $12.35

The drop in value of a share of Summit Systems stock is $12.35

Answer b.

The price of a share would likely be $12.35.

You would receive $12.35 because markets are efficient and would incorporate the information about the new growth rate immediately.