Question

Pepperoni Ltd, a small processed food company had revenues last year of $4.5 million and total costs of $3 million. Pepperoni has 1.4 million shares of common stock outstanding. Gross revenues and costs are expected to grow at 5 percent per year on this existing business. Pepperoni pays tax at 40 cents in the dollar. The dividend payout ratio is 50%.

Required:

(i) If the appropriate discount rate is 10 percent per annum, what is the price per share of Pepperoni Ltd's stock?

(ii) Pepperoni Ltd has decided to start a new project. This project requires an immediate outlay of $2.8 million. In one year, another outlay of $2.1 million will be needed. Earnings from the new project will be a steady $1.4 million (before tax) per year and the first of these will be received two years from today, maintained in perpetuity. What effect will undertaking this new project have on the price per share of Pepperoni's stock? Please calculate the new expected share price.

Answer 1

Pepperoni ltd. had a net profit of $1.5 (i.e., $4.5 - $3) million last year.

 

It paid taxes of 40%, i.e., $ 0.6 million (i.e., 1.5*40%).

 

Therefore EPS (Earnings per share) = $ 0.9 million (i.e., 1.5 – 0.6)

 

The dividend payout ratio is 50%. Therefore, total dividend this year are $ 0.45 million or $ 450,000

 

Number of shares outstanding = 1,400,000

 

Therefore, dividend per share in current year, D0 = $ 450,000/1,400,000 = $0.3214

 

Now, using dividend discount model we can calculate the price of the share.

 

As per this model,

 

Where, r is the required rate of return and g is the expected growth rate.

 

Therefore,

 

Therefore, the price of the share or P = $ 6.75.

 

Now for the new project,

The after-tax profits will be = 1,400,000 – 40% of 1,400,000 = $ 840,000

 

And these profits will be perpetual starting 2 years hence. Therefore, PV of these cash flows after 2 years will be = 840,000/0.10 = $ 8,400,000

 

Now we can calculate the value of the project as follows:

Year	0	1	2
Initial cost	(2,800,000.00)
Further Outlay		(2,100,000.00)
Value of cash flow			8,400,000.00
Net total Cash Flow	(2,800,000.00)	(2,100,000.00)	8,400,000.00
PV Factor	1.00	0.91	0.83
NPV	(2,800,000.00)	(1,909,090.91)	6,942,148.76

 

Therefore, the NPV of the project will be the sum of PVs of future cashflows, i.e., $ 2,233,057.85.

 

To calculate the impact of this project on the price of the share we assume that all the profits will be distributed in the same ratio as now which is 50% distribution rate. And also, we assume that this project was financed from the retained profits.

 

Therefore, total dividend distribution will be as follows:

 

Additional profits = 1,400,000.00

Earnings per share out of new profits = 840,000.00

Dividend paid from new profits = 840,000.00 * 50%

                                                         = 420,000.00

 

Dividend per share from new profits in second year = 0.30

And dividend per share from existing profits in second year = 0.35

Total dividend paid in second year = 0.65

 

So value of share in the second year =

 

Present value of share price:

Year	1.00	2.00
Dividend paid	0.34
Price of share		13.09
Total	0.34	13.09
PV factor	0.91	0.83
PV factor	0.31	10.82

 

Therefore, price of the share today is 0.31+ 10.82 =  $ 11.12

 

The price increases by $ 4.37 due to the new project.