Chiptech, Inc., is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned $1 per share last year and just paid out a dividend of $.50 per share. Investors believe the company plans to maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects this situation to persist indefinitely
a. What is the market price of Chiptech stock? The required return for the computer chip industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t = 1).
b. Suppose you discover that Chiptech’s competitor has developed a new chip that will eliminate Chiptech’s current technological advantage in this market. This new product, which will be ready to come to the market in two years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The plowback ratio will be decreased at the end of the second year, at t = 2: The annual year-end dividend for the second year (paid at t = 2) will be 60% of that year’s earnings. What is your estimate of Chiptech’s intrinsic value per share?
( Hint: Carefully prepare a table of Chiptech’s earnings and dividends for each of the next three years. Pay close attention to the change in the payout ratio in t = 2.)
c. No one else in the market perceives the threat to Chiptech’s market. In fact, you are confident that no one else will become aware of the change in Chiptech’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? In the second year (between t = 1 and t = 2)? The third year (between t = 2 and t = 3)? ( Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)
b. At time 2: $8.551 and at time 0: $7.493
ROE = 20%
b = 5%
g =ROE x b = 20% x 0.5 = 10%
P0 = D1 / k – g = D0 (1 + g) / k – g
= $0.50 x 1.10 / 0.15 – 0.10
g =10%, Plowback = 0.50
EPS has grown by 10% based on last year's earning; This year's earning plowback ratio falls to 0.40 and payout ratio = 0.60
EPS grows by (0.4)(15%) = 6% and payout ratio = 0.60
At time 2: P2 = D3 / k – g = $0.7696 / 0.15 – 0.06 = $8.551
At time 0: V0 = $0.55 / 1.15 + $0.726 + $8.551 / (1.15)2 =$7.493
P0 = $11 and
P1 = P0 (1 + g) = $12.10 (because market believes the stock would grow at 10% every year)
P2 = $8.551 (when market knows about its competitive situation)
P3 = $8.551 x 1.06 = $9.064 (new growth rate = 6%)
1 ($12.10 - $11) + $0.55 / $11 = 0.150 = 15%
2 ($8.551 - $12.10) + 0.726 / $12.10 = -0.223 = -.23.3%
3 ($9.064 - $8.551) + $0.7696 / $8.551 = 0.150 = 15%
This implies that in case of no special information in normal cases, the stock return k = 15%
OceanGate sells external hard drives for $200 each. Its total fixed costs are $30 million, and its variable costs per unit are $140. The corporate tax rate is 30%. If the economy is strong, the firm will sell 2 million drives, but if there is a recession, it will sell only half as many. What is the firm’s degree of operating leverage? If the economy enters a recession, what will be the firm’s after-tax profit?
Janet Ludlow’s firm requires all its analysts to use a two-stage DDM and the CAPM to value stocks. Using these measures, Ludlow has valued QuickBrush Company at $63 per share. She now must value SmileWhite Corporation.
a. Calculate the required rate of return for SmileWhite using the information in the following table:
b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:
First three years
12% per year
9% per year
Estimate the intrinsic value of SmileWhite using the table above and the two-stage DDM. Dividends per share in 2010 were $1.72.
c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company’s intrinsic value with its current market price.
d. Describe one strength of the two-stage DDM in comparison with the constant-growth DDM. Describe one weakness inherent in all DDMs.
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