Question

Summit Systems has an equity cost of capital of

11.5 %11.5%​,

will pay a dividend of

​$1.501.50

in one​ year, and its dividends had been expected to grow by

6.5 %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 %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?

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

​$12.3512.35.

​(Round to the nearest​ cent.)

b. If you tried to sell your Summit Systems stock after reading this​ news, what price would you be likely to​ get?

The price of a share would likely be

​$nothing.

​(Round to the nearest​ cent.)

Answer 1

a).

Using Dividend discount model, we can calculate the price of the stock as D1/(r-g); where D1 is dividend paid in one year, r is equity cost of capital and g is dividend growth rate.

Value of share at growth rate of 6.5% is 1.5/(11.5%-6.5%)

= 1.5/5%

= $30.

Value of share at growth rate of 3% is 1.5/(11.5%-3%)

= 1.5/8.5%

= $17.65

So, Drop in value of the share= 30-17.65= $12.35

b).

After reading the news, the price we would likely get will be based on the revised growth rate of 3%.

So, Price= 1.5/(11.5%-3%)

= 1.5/8.5%

= $17.65