Question

The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next five years. Its latest EPS was $20.00, all of which was reinvested in the company. The firm’s expected ROE for the next five years is 18% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm’s ROE on new investments is expected to fall to 13%, and the company is expected to start paying out 50% of its earnings in cash dividends, which it will continue to do forever after. DEQS’s market capitalization rate is 28% per year. a. What is your estimate of DEQS’s intrinsic value per share? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? (Round your dollar value to 2 decimal places.) Because there is (Click to select) , the entire return must be in (Click to select). c. What do you expect to happen to price in the following year? (Round your dollar value to 2 decimal places.) d. What is your estimate of DEQS’s intrinsic value per share if you expected DEQS to pay out only 30% of earnings starting in year 6? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

Year	ROE	Payout	g	EPS	Dividend
0				$20.00
1	18%	0%	18.0%	$23.60	$0.00
2	18%	0%	18.0%	$27.85	$0.00
3	18%	0%	18.0%	$32.86	$0.00
4	18%	0%	18.0%	$38.78	$0.00
5	18%	0%	18.0%	$45.76	$0.00
6	13%	50%	6.5%	$48.73	$24.36

Growth (g) = ROE x (1 - payout)

EPS = EPS last year x (1 + g)

Divident = EPS x Payout

Price in year 5, P5 = D6 / (r - g) = 24.36 / (28% - 6.5%) = $113.32

Price today, P0 = P5 / (1 + r)^5 = 113.32 / (1 + 28%)^5 = $32.98... a)  

Price in year 1, P1 = P0 x (1 + r) = $32.98 x (1 + 28%) = $42.22... b)

Price in year 2, P2 = 42.22 x 1.28 = $54.04 ... c)

If payout is 30% in year 6, growth, g = 13% x (1 - 30%) = 9.1%

EPS 6 = 45.76 x (1 + 9.1%) = $49.92 and Dividend = 49.92 x 30% = $14.98

Price in year 5 = 14.98 / (28% - 9.1%) = $79.24

Price today = 79.24 / (1 + 28%)^5 = $23.06... d)