Question

XYZ Manufacturing is considering a cash purchase of the stock of PNQ Corp. During the year just completed, PNQ earned $3.50 per share and paid cash dividends of $2.40 per share. PNQ’s earnings and dividends are expected to grow at 15% per year for the next four years, after which they are expected to grow at 5% per year to infinity. Assume that PNQ has a required return of 10% on investments with risk characteristics similar to those of PNQ.

a. What is the expected price per share three years from today?

Answer 1

Dividend in 4th Year = Current Dividend * (1 + growth rate)^4

Dividend in 4th Year = 2.40 * (1 + 0.15)^4

Dividend in 4th Year = $4.20

Dividend in 5th Year = Dividend in year 4* (1 + growth rate)^1

Dividend in 5th Year = 4.20 * (1 + 0.05)^1

Dividend in 5th Year = $4.41

Stock Price at Year 4 = Dividend in year 5 / (Required return - growth rate)

Stock Price at Year 4 = 4.41 / (10% - 5%)

Stock Price at Year 4 = $88.20

expected price per share three years from today = Dividend in Year 4 / (1 + Required return) + Stock Price / (1 + Required return)

expected price per share three years from today = 4.20 / 1.1 + 88.20 / 1.1

expected price per share three years from today = $84