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In: Finance

reverse engineering with abnormal earnings growth model (chapter 7 problem 5E) - analysts forecast forward earnings...

reverse engineering with abnormal earnings growth model (chapter 7 problem 5E) - analysts forecast forward earnings of $2.11 per share and a forecast of $2.67 for 2 years ahead. The firm pays no dividends. the required return is 9%.

what is the long term growth rate in abnormal earnings growth (AEG) implied by a market price of $105.69?

what is the market's forecast of EPS for 3 years ahead.

as I stated earlier - this problem does not have the answer listed in the textbook answers portion of chegg. I have paid for this service and would like to have the solution to this problem. thank you

Solutions

Expert Solution

Answer :

Given Data:

EPS = Earnings per Share

1st Year $ 2.11

2nd Year $ 2.67

Required Rate of Return = 9%

Dividend = no dividend payment , Hence DPS = 0

what is the long term growth rate in abnormal earnings growth (AEG) implied by a market price of $105.69?

P = 1/r + ( Earnings at year2 + (Abnormal Earnings / r - g) )

Here,

p = Market Price

r = required rate of return

g = growth rate

Here,

Abnormal earnings are calculated as follows :

Particulars Year 1 Year 2
Earnings per share $ 2.11 $ 2.67
Dividend Paid 0 0
Dividend reinvested at rate 9% 0
Total Earnings $ 2.67
Less : Normal EPS ( 2.11 x 1.09) $ 2.30
Abnormal Earnings $ 0.37

Hence, P = 1/r x ( Earnings at year2 + (Abnormal Earnings / r - g) )

$105.69 = 1/0.09 x  ( $ 2.67 + ( $0.37 / 1.09 - g )

9.5121 = 2.67 + ( $0.37 / 1.09 - g )

6.8421=( $0.37 / 1.09 - g )

1.09 - g = 0.5408

g = 1.0359

It means long term growth rate in abnormal earnings growth (AEG) implied is 3.59%

what is the market's forecast of EPS for 3 years ahead?

= Normal EPS at Year 2 grows at normal rate of return + Abnormal Earnings

= $ 2.67 x 1.09 + ( $ 2.67 x 3.59%)

= $ 2.91 + $ 0.0959

= $ 3.0062


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