ABC Company has just invented a cheap form of energy. Equity investors with a 16
ID: 2740277 • Letter: A
Question
ABC Company has just invented a cheap form of energy. Equity investors with a 16% required rate of return expect this company to grow at an accelerated rate of 45% per year for the next 3 years and then continue at a constant growth rate of 15% per year. The most recent annual dividend was $4.00 per share.
a.) Draw a timeline showing the expected cash flows to the equity holder over the next four years (of course these cash flows will occur in perpetuity but I just want to see the cash flow for the next four years).
b.) What would investors be willing to pay for the common stock today given these assumptions?
c.) What will happen to the stock price if management revises their estimates of future growth down? Explain.
Explanation / Answer
a) The timeline showing the expected cash flows to the equity holder over the next four years are:
b) Stock price at year 3 (P3) = 6.08 (1.15) / 0.16 - 0.15 = $699.20
Current Stock Price = (6.08+699.20) / (1.16)^3 + 5.29 / (1.16)^2 + 4.60 / 1.16 = $459.74
c) If management revises their estimates of future growth down, it will going to reduce the current and future stock price. Eg. if the growth rate is estimated at 10%, then P3 = 6.08 (1.10) / 0.16-0.10 = $111.47. But at 15% growth, the P3=$699.20.
D1 D2 D3 D4 Dividend amount to Equity holders $4.60 $5.29 $6.08 $6.99