Question

7. Halliford Corporation expects to have earnings this coming year of $3 per share. Halliford plans to retain all of its earnings for the next two years. For the subsequent two years, the firm will retain 50% of its earnings. It will then retain 20% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 25% per year. Any earnings that are not retained will be paid out as dividends. Assume Halliford’s share count remains constant and all earnings growth comes from the investment of retained earnings. If Halliford’s equity cost of capital is 10%, what price would you estimate for Halliford stock?

Answer 1

Price of stocks is calculated as follows,

Price of stock =Present Value of Dividend+Present Value of Terminal Value

Year	EPS	ROE	Retention ratio	g = ROE x Retention ratio	Payout ratio	Dividend = EPS x Payout ratio	Terminal value	PV factor @ 10%	PV of Dividend	PV of Terminal value
1	3.00	25%	100%	25%	-	-		0.91	-	-
2	3.75	25%	100%	25%	-	-		0.83	-	-
3	4.69	25%	50%	12.5%	50%	2.34		0.75	1.76	-
4	5.27	25%	50%	12.5%	50%	2.64		0.68	1.80	-
5	5.93	25%	20%	5%	80%	4.75	94.92	0.68	-	64.83
Price of share	68.39

Note:

Every year Earnings gets increased by g.

Terminal value =D₅/(Re-g)

Terminal value =4.746/(0.10-0.05)

Terminal value =94.42

Price of stock =Present Value of Dividend+Present Value of Terminal Value

Price of stock =(1.76+1.80)+64.83

Price of stock =68.39