Question

Xylitor is a relatively new biotech firm, with an exciting new product that is anticipated to come to market in approximately 2 years (following regulatory approval of the product, which is Xylitor's first). A share of Xylitor is trading at $25. Xylitor has not paid a dividend yet, but anticipates initiating a dividend in 3 years (again, after approval of the product). The required return on Xylitor is 12% per year. Assuming the project/company is considered to be a perpetuity, if earnings per share for the new product (after approval) are anticipated to be $5.00 per share, and the dividend payout will be 100% of earnings, what is your best estimate about the market's probability of product approval?

Answer 1

Dividend payout = 100%

Therefore, Dividend per share (DPS) = EPS = $ 5 / share

Required return (r) = 12%

The project is to be considered perpetuity, so using the dividend discount model we can find the value of a stock at T = 2 years (since the first dividend would be paid out at T = 3 years).

Stock price (at T = 2) = DPS (at T=3) / r = $5 / 0.12 = $ 41.67

Discounting the stock price to the present,

Stock price (at T = 0) = Stock price (at T = 2) / (1 + r)^2 = $ 41.67 / 1.12^2 = $ 33.216, this should be the value of a stock if the new product is approved.

The current market price of a stock = $ 25

The market's probability of product approval

= The current market price of a stock / the value of a stock if the new product is approved

= $ 25/ $ 33.216

= 75.26%