Question

Jeckell and Hyde will have earnings per share of $3 for year 1. J&H plans to retain 80% of their earnings in years 1 and 2. In years 3, 4 and 5, J&H will retain 60% of the earnings. Thereafter, J&H will retain 30% of their earnings from year 6 and on. Retained earnings will be invested into projects with an expected return of 18% per year. If J&H's equity cost of capital is 12%, calculate the stock price and show all work.

Answer 1

The fixed proportion of earnings retained every year and reinvested at an expected return of 18%, generates a growth in the firm's earnings as per the relationship below:

Annual Growth in Earnings for year (t+1) = Proportion of Earnings Reinvested at the end of Year t x Expected Return on Reinvestments. The remaining earnings are paid out as dividends which are to be discounted by the cost of capital to the current time (t=0) and summed to arrive at the stock price.