Question

The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next five years. Its latest EPS was $18.50, all of which was reinvested in the company. The firm’s expected ROE for the next five years is 14% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm’s ROE on new investments is expected to fall to 9%, and the company is expected to start paying out 40% of its earnings in cash dividends, which it will continue to do forever after. DEQS’s market capitalization rate is 25% per year. a. What is your estimate of DEQS’s intrinsic value per share? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? (Round your dollar value to 2 decimal places.) Because there is , the entire return must be in . c. What do you expect to happen to price in the following year? (Round your dollar value to 2 decimal places.) d. What is your estimate of DEQS’s intrinsic value per share if you expected DEQS to pay out only 20% of earnings starting in year 6? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

		Growth Rate =ROE*Retention Rate
		ROE=14%	0.14
		Retention Rate=100%	1
		Growth Rate =ROE*Retention Rate=	0.14	(For next 5 years)
		ROE year 6 onwards=9%	0.09
		Retention Rate=100-40=60%	0.6
		Growth rate from year 6 to infinity	0.054	(0.09*0.6)
		Market Capitalization Rate	0.25
		Required rate of return	0.25
		Earning Per share (EPS)inyear 0	$18.50
		N	A	B=A/(1.25^N)
		Year	EPS	Present Value
	EPS1=18.5*1.14	1	$21.09	16.87
	EPS2=EPS1*1.14	2	$24.04	15.39
	EPS3=EPS2*1.14	3	$27.41	14.03
	EPS4=EPS3*1.14	4	$31.25	12.80
	EPS5=EPS4*1.14	5	$35.62	11.67
			SUM	$70.76
		EPS in year 6=35.62*(1+0.054)	$37.54
		Growth Rate constant from year 6	0.054
		Required Rate of Return	0.25
		Present Value in year5 of future EPS	$191.55	(37.54/(0.25-0.054)
		Present Value in year 0 of future EPS	62.76687	(191.55/(1.25^5)
		PRESENT VALUE OF ALL FUTURE EPS	$133.53	(62.7669+70.76)
		INTRINIC VALUE PER SHARE	$133.53
		Intrinsic value Next year
		N	A	B=A/(1.25^N)
		Year	EPS	Present value
		1	$24.04	19.23408
		2	$27.41	17.54148096
		3	$31.25	15.99783064
		4	$35.62	14.59002154
	(Horizon value)	4	$191.55	78.45858522
			SUM	145.8219984
		Intrinsic value Next year	$145.82
		If Payout is only 20%
		Expected Growth Rate=9*(1-0.2)	0.072
		EPS in year 6=35.62*1.072	$38.18
		Intrinsic value in Year5=38.18/(0.25-0.072)=		$214.52
		Present value of $214.52=	$70.29	(214.52/(1.25^5)
		Intrinsic value today=70.29+70.76	$141.06