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 $15.50, all of which was reinvested in the company. The firm’s expected ROE for the next five years is 19% 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 14%, and the company is expected to start paying out 35% of its earnings in cash dividends, which it will continue to do forever after. DEQS’s market capitalization rate is 22% 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.) Intrinsic Value 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 no dividend , the entire return must be in capital gains . 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 15% of earnings starting in year 6? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Intrinsic Value

Answer 1

Answer:

(A):

GIVEN, LATEST EPS = $15.50

FOR NEXT FIVE YEARS:

EXPECTED ROE FOR NEXT FIVE YEARS = 19% PER YEAR

THE FIRM WILL NOT PAY ANY DIVIDEND FOR NEXT FIVE YEARS

LET US CALCULATE THE GROWTH RATE = ROE * (1-DIVIDEND PAYOUT RATIO)

=19%*(1-0%)

= 19%

HENCE,

EPS AT THE END OF FIVE YEARS = 15.50*(1+19)⁵

STARTING YEAR 6:

CONSTANT GROWTH RATE= ROE*(1- DIVIDEND PAYOUT RATIO) =14% * (1- 35%)=9.1%

EPS IN YEAR 6 = (15.50*(1+19%)⁵ ) * (1+9.1%)

DIVIDEND IN YEAR 6 = (15.50*(1+19%)⁵ ) * (1+9.1%) * 35

HORIZON VALUE:

HORIZON VALUE OF SHARE AT THE END OF YEAR 5 = DIVIDEND IN YEAR 6 / (CAPITALIZATION RATE - CONSTNT GROWTH RATE)

= (15.50* (1+19%)⁵ * (1+9.1%) * 35% / (22% - 9.1%)

= $ 109.4884

INTRINSIC VALUE OF SHARE NOW:

INTRINSIC VALUE OF SHARE NOW= 109.4884 / (1+22%)⁵

= 40.5107

INTRINSIC VALUE 40.5107

(B):

THERE IS NO DIVIDEND TILL 5 YEAR AND HENCE ENTIRE RETURN IS DUE TO CAPITAL GAIN.

AS SUCH, PRICE NEXT YEAR WILL BE = 40.5107 * (1+22%) = $ 49.4230

PRICE WILL INCREASE BY 22% PER YEAR UNTIL YEAR 6

BECAUSE THERE IS NO DIVIDEND, THE ENTIRE RETURN MUST BE IN CAPITAL GAINS

PRICE IN ONE YEAR IS $49.4230

(C):

PRICE IN TWO YEARS = 40.5107 * (1+22%)² = $60.29

PRICE IN ONE YEAR IS $60.29

(D):

IF DIVIDEND PAYOUT STARTING YEAR 6 IS 15%

CONSTANT GROWTH RATE STARTING YEAR 6 = ROE * (1- DIVIDEND PAYOUT RATIO)

= 14% * (1-15%)

= 11.9%

HORIZON VALUE OF SHARE AT THE END OF THE YEAR 5 = DIVIDEND IN YEAR 6 / (CAPITALIZATION RATE - CONSTANT GROWTH RATE)

= (15.50 * (1+19%)⁵ * (1+11.9%) * 15% / (22% - 11.9%)

= 61.47046

INTRINSIC VALUE OF SHARE NOW = 61.47046 / (1+22%)⁵

INTRINSIC VALUE $ 22.7440929