Question

Early in 2010, Danielle, the chief financial officer for Sam Manufacturing, was given the task of assessing the impact of a proposed risky investment on the firm’s stock value. To perform the necessary analysis, Danielle gathered the following information on the firm’s stock. During the immediate past 5 years (2005–2009), the annual dividends paid on the firm’s common stock were as follows:

Year	Dividend per share
2009	$2.90
2008	2.70
2007	2.55
2006	2.40
2005	2.30

Currently, the required return on the common stock is 15%. Danielle’s research indicates that if the proposed investment is undertaken, the 2010 dividend will rise and the annual rate of dividend growth will increase to 14%. She feels that in the best case, the dividend would continue to grow at this rate each year into the future and that in the worst case, the 14% annual rate of growth in dividends would continue only through 2012, and then, at the beginning of 2013, would return to the rate that was experienced between 2005 and 2009. As a result of the increased risk associated with the proposed risky investment, the required return on the common stock is expected to increase by 3% to an annual rate of 18%, regardless of which dividend growth outcome occurs.

Armed with the preceding information, Danielle must now assess the impact of the proposed risky investment on the market value of Sam’s stock. To simplify her calculations, she plans to round the historical growth rate in common stock dividends to the nearest whole percent.

Required

a. Find the current value per share of Sam Manufacturing’s common stock.

b. Find the value of Sam’s common stock in the event that it undertakes the proposed risky investment and assuming that the dividend growth rate stays at 14% forever. Compare this value to that found in part a. What effect would the proposed investment have on the firm’s stockholders? Explain.

c. On the basis of your findings in part b, do the stockholders win or lose as a result of undertaking the proposed risky investment? Should the firm do it? Why?

d. Rework parts b and c assuming that at the beginning of 2013 the annual dividend growth rate returns to the rate experienced between 2005 and 2009.

Answer 1