Newman manufacturing is considering a cash purchase of the stock of Grips Tool.
ID: 2760828 • Letter: N
Question
Newman manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned $3.43 per share and paid cash dividends of $1.73 per share (D0=$1.730. Grips earnings and dividends are expected to grow at 20% per year for the next 3 years, after which they are expected dto grow 6% per year to infinity. What is teh maximum price per share that Newman should pay for Grips if it has a required return of 12% on investments with risk characteristics similar to those of Grips
A.) the maximum price per share that Newman should pay for Grips is $?
Explanation / Answer
Solution:
P0 = Present value of dividends during initial growth period
+ present value of price of stock at end of growth period.
Steps 1 and 2: Value of cash dividends and present value of annual dividends
Present Value
t
D0
FVIF20%,t
Dt
PVIF12%,t
of Dividends
1
$1.73
1.2
$2.08
0.8928571
$1.85
2
1.73
1.44
$2.49
0.7971939
$1.99
3
1.73
1.728
$2.99
0.7117802
$2.13
$5.97
Step 3: Present value of price of stock at end of initial growth period
D3 + 1 = $5.97 x (1 + .06)
D4 = $6.33
P3 = [D4 ¸ (ks - g2)]
P3 = $6.33 ¸ (.12 -.06)
P3 = $105.5
PV of stock at end of year 3 = P3 x (PVIF12%,3)
PV = $105.5 x (.712)
PV = $75.09
Step 4: Sum of present value of dividends during initial growth period and present value price of stock at end of growth period
P0 = $5.97 + $75.09
P0 = $81.06
Hence, the maximum price per share that Newman should pay for Grips is $81.06.
Present Value
t
D0
FVIF20%,t
Dt
PVIF12%,t
of Dividends
1
$1.73
1.2
$2.08
0.8928571
$1.85
2
1.73
1.44
$2.49
0.7971939
$1.99
3
1.73
1.728
$2.99
0.7117802
$2.13
$5.97