Question

Solar Energy currently (Year 0) has Earnings Per Share (EPS) of $3 and pays no dividend. You anticipate that EPS will grow at a 20% annual rate for the next three years (Years 1, 2 and 3) and then beginning in Year 4 EPS will grow at a constant 5% rate. You project the company will pay dividends of $0.25 per share (Year 1), $0.50 (Year 2), and $0.75 (Year 3). Beginning in Year 4 you anticipate Solar Energy will pay dividends every year equal to 30% of their EPS.

If you have a 10% discount rate how much would you pay for a share of Solar Energy?

Answer 1

Year	EPS	Dividend
1	=3*1.2=3.6	0.25
2	3.6*1.2=4.32	0.5
3	4.32*1.2=5.184	0.75
4	5.184*1.05=5.44	=30%*5.44=1.63

Present value (PV) = sum of present value of all future cash flows

Assuming returns are generated from dividends only,

After end of 3 years there is a perpetuity model with constant dividend growth which can be calculated using the formula Dividend * (1+ dividend growth rate)/ (return rate - growth rate) which needs to be discounted back from year 4 to year 0 (present value)

PV = 0.25/(1+10%)^1+0.5/(1+10%)^2+0.75/(1+10%)^3+ 1.63*(1+5%)/(10%-5%)/(1+10%)^4=$24.58