Question

Q1: Sam Inc.

Sam Inc., is a rapidly growing manufacturing company involved in selling personal computers (PCs), servers, data storage devices, network switches, and software. The most recent annual (2018) dividend payment of Sam was $2.50 per share. The firm’s financial manager expects that these dividends will increase at 8% annual rate over the next three initial growth periods (IGP). At the end of three years (IGP), the firm’s is expected to result in a slowing of the dividend growth rate to 4% per year for the foreseeable future. Assume that the appropriate discount rate is 10%

Required:

1. Discuss three set of actions when the securities are undervalued, overvalued and correctly priced.
2. Estimate the value of Sam’s shares using variable (two-stage) growth model.
3. State clearly any limitations and assumptions that you made in your calculations.

Answer 1

a)

When the security is undervalued i.e., its market price is less than its intrinsic or fair value, we should buy the security as we make a profit when the price rises to its fair value.

When the security is overvalued i.e., its market price is more than its intrinsic or fair value, we should sell the security as the price will fall to its fair price and we won't incur any losses.

When the security is correctly priced, the market price is equal to its fair value and there is no profit or loss from buying or selling the share.

b) 2 stage dividend growth model

D0 = $2.5

IGP of 3 years = 8%

Growth after IGP = 4%

Discount rate = 10%

D1 = D0*(1+r) = 2.5*1.08 = 2.7

D2 = D1*(1+r) = 2.7*1.08 = 2.9

D3 = D2*(1+r) = 2.9*1.08 = 3.15

According to DDM,

Price of share at yr 3 = D3*(1+r)/(r-g) = $54.58

Currwnt share price = 54.58/(1+r)^3 = $41

Hence the current share price is $41

c) Limitation and Assumtions in two stage growth model

The following are the limitations of two stage growth models

1. Error in estimation of length of first satge.
2. Direct fall in growth rate from 8% to 4%.
3. The growth rate usually varies from year to year. Assuming a constant growth rate from yr 1 to 3 and then 4% forever isn't practical.
4. Assumption of discount rate of 10% may not be true as the discount rate of a firm can change over the years.

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