Warner Company, which is a manufacturer of computer parts, has been in business
ID: 2763354 • Letter: W
Question
Warner Company, which is a manufacturer of computer parts, has been in business only a few years. Its board of directors decided to pay a dividend next year to help boost the attractiveness of its shares. It will pay $0.28 in dividends per share next year, after which its dividends are expected to grow at 5 percent per year into the foreseeable future. Given a share beta of 2.1, a market rate of return of 9 percent, and a 6 percent T-bill rate, should the company's shares be purchased if they are currently selling for $3.50? As a financial analyst, however, you have decided to take into consideration the life cycle of the industry and have predicted that the current growth rate of 5 percent will be reduced to 3 percent from year 4 and the latter growth rate will continue into an indefinite future. Would you be your decision now?Explanation / Answer
Hi,
Please find the correct answer below:
Value of stock = D1/ (k - g)
where:
D1 = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return, which can be estimated using the Capital Asset Pricing Model or the Dividend Growth Model (see Cost of Equity)
g = the expected dividend growth rate (note that this is assumed to be constant)
D1 = 0.28
Cost of equity or k = Risk free rate of return + Beta × (market rate of return – risk free rate of return)
= 0.06 + 2.1*(0.09-0.06)
= 0.123
Expected Share price = 0.28/(0.123-0.05)
= 3.84
The share is currently undervalued; hence, the company’s shares should be purchased.
New price
D1 = 0.28
D2 = 0.28*(1.05) = 0.294
D3 = 0.28*(1.05)*(1.05) = 0.3087
D4 =0.3087*(1.03) = 0.317961
Price = 0.28/(1.123)^1+0.294/(1.123)^2+0.3087/(1.123)^3+(0.31761/(1.123)^3)/(0.123-0.05)
= 3.77
The share is currently undervalued still; hence, the company’s shares should be purchased.