Question

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). (Round your answer to 2 decimal places.)

Market price

$

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.) (Round your answer to 2 decimal places.)

Book value per share

$

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. (Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)

c-1.	What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Rate of return

%

c-2.	What will be the rate of return on Chiptech stock in the second year (i.e., between t = 1 and t = 2)? (Negative value should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

Rate of return

%

c-3.	What will be the rate of return on Chiptech stock in the third year (i.e., between t = 2 and t = 3)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Rate of return

%

Answer 1

EPS = $ 1

DPS = $ 0.5

Dividend payout ratio = 50%

ROE Return on equity = 20%

Expectation is that this situation to persist indefinitely i.e. the dividend to remain same at $ 0.5

Required return of computer chip industry or K_e 15%

We can use dividend capitalization to calculate market price of the share

= Dividend / K_e

= 0.5 / 15%

= $ 3.33

B)

Year	1	2	3
EPS	1	0.75	0.75
DPS	0.5	0.45	0.45
Dividend payout	50%	60%	60%
ROE	20%	15%	15%
Market price	3.33
Book value		3

As ROE falls to 15% therefore EPS also falls

EPS = 1 * 15 / 20 = > 0.75

And DPS = EPS * Dividend Payout

= 0.75 * 60% => 0.45

Book Value of per share at year end 2 = Dividend / Required rate of return

Dividend = $0.45

Required rate of return = 15%

= 0.45 / 15% => $ 3 per share

C) Return is calculated by predicting the market price based on dividend capitalization.

Using above table

1) Rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)

Price at T ₀ = 3.33

Price at T 1 = 3.33

Return = 0%

As there is no growth in dividend so the price may remain same in year T1

2)

Rate of return on Chiptech stock in the second year (i.e., between t = 1 and t = 2)

Price at T1 = 3.33

Price at T2 = 3

Loss from price fall = 3 -3.33 =>0.33

Return = 0.33 / 3.33 => - 10%

3)

Rate of return on Chiptech stock in the second year (i.e., between t = 2 and t = 3)

Price at T2 = 3

Price at T3 = 3

Return = 0%