Question

PARTS A-F ARE ALREADY SOLVED. I just need G - I

Martin Office Supplies paid a $3 dividend last year. The dividend is expected to grow at a constant rate of 6 percent over the next four years. The required rate of return is 12 percent (this will also serve as the discount rate in this problem). Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a. Compute the anticipated value of the dividends for the next four years.

b. Calculate the present value of each of the anticipated dividends at a discount rate of 12 percent.

c. Compute the price of the stock at the end of the fourth year (P4).

d. Calculate the present value of the year 4 stock price at a discount rate of 12 percent.

e. Compute the current value of the stock.

f. Use the formula given below to show that it will provide approximately the same answer as part e.

g. If current EPS were equal to $6.95 and the P/E ratio is 10% higher than the industry average of 7, what would the stock price be?

h. By what dollar amount is the stock price in part g different from the stock price in part f?

i. With regard to the stock price in part f, indicate which direction it would move if:

(1) D1 increases

(2) K_e increases

(3) g increases

Answer 1

As mentioned in the question, only parts (g) to (i) are needed.

(G)

EPS = $6.95

Industry P/E ratio = 7

The P/E ratio for company is 10% higher than the Industry average.

Thus, the Company's P/E ratio = 7*(1.10) = 7.7

Price/ Earnings = 7.7

Thus, Price of share = 7.7* EPS

Price of share = 7.7* $6.95

Price of share = $ 53.515

(g) The Difference can be calculated using $53.515 - Price of Stock in part (f)

(h)

The Price of a share is given as follows:

• A direction relation is observed between D1 (dividend in the next period) and the price.
• An indirect relation exists between the price of a share and its Ke (Cost of Equity)
• A direction relation exists between the price of a share and its g (growth), as it reduces the cost of equity.

Thus, to answer:

(1) As D1 increases, the stock price would increase.

(2) As Ke increases, the stock price would decrease.

(3) As g increases, the stock price would increase.

These conclusions make sense intuitively too, as the share price of a company's stock is expected to increase when a high dividend (D1) and growth (g) is expected.