Question

Question 1:

It is now May 16, 2020. “Ace Engineering” of Oakland California has just developed a solar panel capable of generating 200% more electricity than any solar panel currently on the global market. As a result, the firm is expected to experience a 30% annual growth for the next five years. By the end of five years other firms will have developed comparable technology, and Ace’s growth rate will slow to 8% per year indefinitely. Stockholders require a return of 12% on the firm's stock. The most recent annual dividend D_0, which was paid yesterday, was $1.50 per share.

a. Calculate the expected dividends for 2020 through 2025.

b. Calculate the value of the stock today. Assume that the stock is traded at the NASDAQ with a price of $120. Is this stock Overvalued/Undervalued?

c. Calculate the Dividend yield in 2020.

d. How does this model differs from a TWO STAGE Model that we have learned in class. Comment analytically.

e. What do we mean by the term Market Efficiency? Do you believe that Markets are Efficient? Carefully explain your answer.

Answer 1

Solution:

We have Growth rate (g) = 30% for the first 5years, then 8% per year indefinitely.

The required rate of return by shareholders (Re) = 12%, D0 = $1.5 per share

a) Expected dividend for 2020 through 2025

g= 30% upto 2024 & 8% year after definitely.

Year	dividend ($)
2020	1.5 * 1.3 = 1.95
2021	1.95 * 1.3 = 2.535
2022	2.535 * 1.3 = 3.295
2023	3.295 * 1.3 = 4.283
2024	4.283 * 1.3 = 5.568
2025	5.568 * 1.08 = 6.013

b) Calculation of stock price today

Stage 1) Present value of dividends from 2020 to 2024

= 1.95/(1.12) + 2.535/(1.12)^2 + 3.295/(1.12)^3 + 4.283/(1.12)^4 + 5.568/(1.12)^5

= $ 11.99

Stage 2) By using gordans constant growth model

price of a stock in the 5th year = D5 * 1.08 / (Re- g)

= 5.568 * 1.08 / 0.12 - 0.08

= 6.013 / 0.04

= $ 150.33

The present value of stock price today = 150.33 / (1.12)^5

= $ 85.30

Value of stock today = Stage 1 + Stage 2

= $ 11.99 + $ 85.30

= $ 97.29

The stock is trading at $ 120, Hence a stock is overvalued as compared to its intrinsic value & we should go short to maximise this opportunity.

c) Dividend Yield in 2020

Price of share in 2020

= Present value of dividends from 2021 to 2024 + present value of stock price in year 5

= 2.535/(1.12)^1 + 3.295/(1.12)^2 + 4.283/(1.12)^3 + 5.568/(1.12)^4 + 150.33/(1.12)^4

=$ 11.48 + $ 95.53

= $ 107.01

Dividend in 2020 = $ 1.95

Dividend yield in 2020 = 1.95 / 107.01 * 100 = 1.82%

d) The two stage model basically involves an increasing growth rate for some period followed by a decreasing growth rate in some years & then grwoth rate becomes constant for years thereafter.

Whereas if we see in above problem we have constant growth rate in first 5 years and then constant growth rate forever.

The difference in two stage model is possible as growth rate is subject to company & the industry to which it belongs.So there is no thumb rule for two stage model it can be differ company wise.

e) The Term Market efficiency implies that how well the prices at which the shares are quoted reflect all the relevant available information about that stock, such that there is no possibility of beating the market.

I believe that the markets are efficient but there are degrees to how much extent markets are efficient, like weak, semi & strong efficiency because everyone is tracking the markets & aware of all the information.