Question

4. There are two corporations, Burns Enterprises and Kwik-E-Mart. Each firm’s stock currently trades at $15.00, and they appear identical to outsiders. However, based on their private information, Kwik-E-Mart management believes things are going well. Business has increased substantially since the new Squishee flavors were introduced. They expect to be able to raise their annual dividend to $0.50 next year and that it will grow by 3.2% thereafter. On the other hand, Burns Enterprises expects to pay major regulatory fines and to have to spend heavily to limit future releases of radioactive waste into nearby streams. Burns’ management believes the firm will have to lower its annual dividend to $0.30 next year and that dividends will grow by only 1.8% thereafter. Neither firm has any debt and the required rate of return on equity is 5%.

   Each corporation considers issuing some new stock.

   1. Would Burns Enterprises want to issue additional shares at the current $15.00 share price? Briefly explain.

   2. Would Kwik-E-Mart want to issue additional shares at the current $15.00 share price? Briefly explain.

Answer 1

Intrinsic value of stock as per Gordon Growth Model is given by:

P= D1 / r−g

where:
P=Intrinsic stock price
g=Constant growth rate expected for
dividends, in perpetuity
r=Constant cost of equity capital for the
company (or rate of return)
D1 =Value of next year’s dividends
​  

Using the above formula, the intrinsic stock value is calculated below for both companies:

Kwik-E-Mart

P = 0.50 / 5%- 3.2% = 0.50 / 1.8% = $27.78 ( > current market price $15)

Burns Enterprises

P = 0.30 / 5%- 1.8% = 0.30 / 3.2% = $9.38 ( < current market price $15)

Burns Enterprises will not be able to issue additional stock at current market price as its intrinsic value is less than the current market price.

Kwik-E-Mart could easily issue additional shares at the current $15.00 share price as its intrinsic value is higher than the current market price, making the equity issue very attractive for the investors.