Question

Summit Systems has an equity cost of capital of 11.5 % ​, will pay a dividend of ​$1.00 in one​ year, and its dividends had been expected to grow by 7.0 % per year. You read in the paper that Summit Systems has revised its growth prospects and now expects its dividends to grow at a rate of 2.5 % per year forever

a. What is the drop in value of a share of Summit Systems stock based on this​ information?

b. If you tried to sell your Summit Systems stock after reading this​ news, what price would you be likely to​ get? Why?

Answer 1

a. The drop in the value of share is computed as shown below:

Original price is computed as follows:

= Dividend in one year / ( equity cost of capital - growth rate)

= $ 1 / ( 0.115 - 0.07)

= $ 22.22 Approximately

Price after revised growth rate is computed as follows:

= Dividend in one year / ( equity cost of capital - growth rate)

= $ 1 / ( 0.115 - 0.025)

= $ 11.11 Approximately

So, the drop in value will be as follows:

= $ 22.22 - $ 11.11

= $ 11.11

b. The price is computed as follows:

= Dividend in one year / ( equity cost of capital - growth rate)

= $ 1 / ( 0.115 - 0.025)

= $ 11.11 Approximately

The price is likely to be $ 11.11, because it is already published in the paper that Summit Systems has revised its growth rate to 2.50%, which implies that the market already knows this information. This further implies that the revised growth rate has been applied.

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