Question

Derek’s company has existing assets that generate Earnings Per Share EPS of $5. If Derek does not invest except to maintain existing assets, EPS is expected to remain constant at $5 a year. However, starting next year, Derek an opportunity to invest $3 per share a year in developing a new technology. Each investment is expected to generate a 20% return (assume that this return is not compounded, so each year the return is 3 x .2). The technology will be fully developed by the end of the fith year. What will be the stock price and PE ratio assuming that investors require a 12%? [Hint: use the dividend discount model]

Answer 1

	Calculation Of Terminal Value Of Project At End Of Fifth Year
	= Return for 6th year = `$5 + ($3*0.2)
			=$5.6
	Therefore terminal value at the end of the fifth year
		=$5.6/0.12
		=46.667
	Calculation of Present Value Of Future Cashflow
	Year	Cash Flow	Discounting Factor @12%	Discounted Cash Flow
	1	5	0.893	4.464
	2	5	0.797	3.986
	3	5	0.712	3.559
	4	5	0.636	3.178
	5	5	0.567	2.837
	5	46.667	0.567	26.480
			NPV	44.504
	Stock Price =44.504
	PE Ratio = Stock Price / EPS
	=	44.504/5
	=	8.90
	Note: It is assumed that the new project will start to give return from the 6th year.