Question

Stock 1: The Binkelman Corporation has just announced that it plans to introduce a new solar panel that will greatly reduce the cost of solar energy. As a result, analysts now expect the company’s earnings, currently $5 per share to grow by 50 percent per year for the next two years, by 25 percent per year for the following two years, and by 8 percent per year, thereafter. Blinkelman does not currently pay a dividend, but it expects to pay out 20 percent of its earnings beginning two years from now and to continue to pay dividends at the same level. The required rate of return for this company is 20 percent for now. Analysts think that it will stay at that level for the next five years and then it decreases to 15%.

Stock 2: Sports Novalties, Inc. has experienced an explosion in demand for its featured football novelties. The firm currently pays a dividend of $0.25 per share. This dividend is expected to increase to $0.75 per share one year from now. It is expected to grow at a rate of 15% per year for the following three years and then growth rate is expected to decrease to 10% and stay at that level. The required return for Sports Novalties is 16% and estimated to stay at that level for three more years and it will be 12% thereafter.

a)Calculate the price of Stock 1 today.

b)Calculate the price of Stock 2 today.

c) Suppose Stock 1 is selling for $25 in the market right now. Decide whether Mary should include Stock 1 in the portfolio of her clients or not and briefly justify your decision.

d)Suppose Mary purchased Stock 2 today with an intention of selling it a year later. Suppose a year has passed and Mary is getting ready to sell her shares. Today, the company announced experiencing some financial difficulties and the required rate of return on company shares suddenly changed to 15% indefinitely. Calculate the new price for Stock 2. Calculate the return she earned on her investment during her 1-year holding period and decompose this return into dividend yield and capital gains yield components.

Answer 1

a). Price of Binkelman Corporation = $29.35 per share

b). Price of Sports Novalties = $42.52 per share

c). If Stock 1 (Binkelman Corporation) is selling for $25 when its intrinsic value is $29.95 then it is undervalued and the market should realise its intrinsic value in time, so it should be included in the portfolio.

d). Price of Stock 2, one year later = $18.29

1-year holding period return = (new price + dividend received - old price)/old price

= (18.29 + 0.75 -42.52)/42.52 = -55.22%

Capital gains yield = (new price/old price)-1 = (18.29/42.52)-1 = -56.99%

So, dividend yield = HPR - capital gains yield = -55.22% + 56.99% = 1.76%