Question

1. 1. In a galaxy far far away, Luke Skywalker was a Tatooine farmboy who rose from humble beginnings to become one ofthe greatest Jedi the galaxy has ever known. After settling down, Luke Skywalker has been investing in the stockmarket for some time, buying mostly high-quality growth stocks as a way to achieve long-term growth and capitalappreciation. He feels that with the limited time he has to devote to his security holdings, high-quality issues are his bestbet. He has become a bit perplexed lately with the market, disturbed that some of his growth stocks aren’t doing evenas well as many good-grade income shares. He therefore decides to have a chat with his broker, Minch Yoda. During their conversation, it becomes clear that both Yoda and Luke are thinking along the same lines. Yoda pointsout that dividend yields on income shares are indeed way up and that, because of the state of the economy, theoutlook for growth stocks is not particularly bright. He suggests that Luke seriously consider putting some of hismoney into income shares to capture the high dividend yields that are available. After all, as Yoda says, “where thepayoff comes from as how much it amounts to, the bottom line is not so much!” They then talk about a high-yieldpublic utility stock, Galactic Empire Power. Yoda digs up some forecast information about Galactic Empire andpresents it to Luke for his consideration:

2. Year  Expected EPS ($)     Expected Dividend Payout Ratio (%)

   2016	$3.25	40%
   2017	$3.40	40%
   2018	$3.90	45%
   2019	$4.40	45%

   
   2020           $5.00                                   45%                         

   The stock currently trades at $60 per share. Yoda thinks that within five years it should be trading at $75 to $80 a share. Luke realizes that to buy the Galactic Empire stock, he will have to sell his holdings of Han Solo Industries—a highly regarded growth stock that Luke is disenchanted with because of recent substandard performance.

   determine the amount of annual dividends Galactic Empire can be expected to pay over the years 2016 to 2020.

Answer 1

Year	Expected EPS ($)	Expected Dividend Payout(DPO) Ratio (%)	Amt. of annual dividends(EPS*DPO)
2016	$3.25	40%	3.25*40%=	1.3
2017	$3.40	40%	3.40*40%=	1.36
2018	$3.90	45%	3.90*45%=	1.755
2019	$4.40	45%	4.40*45%=	1.98
2020	$5.00	45%	5.00*45%=	2.25

Year	Expected EPS ($)	Expected Dividend Payout(DPO) Ratio (%)	Amt. of annual dividends(EPS*DPO)	Growth rate,g =(Current yr.-Prev. yr.)/Prev.yr.
2016	$3.25	40%	3.25*40%=	1.3
2017	$3.40	40%	3.40*40%=	1.36	4.62%
2018	$3.90	45%	3.90*45%=	1.755	29.04%
2019	$4.40	45%	4.40*45%=	1.98	12.82%
2020	$5.00	45%	5.00*45%=	2.25	13.64%
				Sum=	60.12%
					15.03%	Av.growth rate over the 5 yrs.

Taking the average dividend growth rate, we can get the cost of equity

to discount the expected dividend cash flows---

ke=(Next dividend/ current stock price)+Av. Growth rate

ie.ke=(1.3/60)+15%=

17.17%

Discounting the expected dividend cash flows at this cost of equity, we can get the

current price of stock --at both the ranges, $ 75 & $ 80 terminal value

(1.3/1.1717^1)+(1.36/1.1717^2)+(1.755/1.1717^3)+(1.98/1.1717^4)+(2.25/1.1717^5)+(75/1.1717^5)=

39.22

&

(1.3/1.1717^1)+(1.36/1.1717^2)+(1.755/1.1717^3)+(1.98/1.1717^4)+(2.25/1.1717^5)+(80/1.1717^5)=

41.49

So, the intrinsic value of the stock, based on the expected dividend cash flows & its terminal value at end yr. 2020 seems to range between

39 & 41

whereas,

the market price is $ 60

so, Galactic seems to be more of a growth stock than a value stock---ie he can earn more thro'price appreciations , than dividend yields.