Question
In: Finance
NZ Boatbuilders, Ltd. has some outstanding projects to develop. During the next three years these projects...
NZ Boatbuilders, Ltd. has some outstanding projects to develop.
During the next three years these projects are expected to earn a
25% return. However, these projects will be no longer be available
beginning in the fourth year. At that time, the firm is expected to
begin growing at a constant long-term growth rate of 4%, reflecting
the long-run expected return on projects of 10%. (Note: this is the
required return for NZ Boatbuilders projects.) During the rapid
growth period, the firm’s dividend payout ratio will be relatively
low (20%) in order to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will also be accompanied by
an increase in the dividend payout to 60%. Last year’s earnings
were 0 E =$2.00 per share, a dividend payout ratio of 20%. The tax
rate is 30%.
a. What should the current price of the common stock be?
b. What characteristics must the projects have in the first 3
years and why would those characteristics no longer be true
beginning in year 4?
Solutions
Expert Solution
Part (a)
Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row contains your answer. All financials are in $.
| Year, n | Linkage | 0 | 1 | 2 | 3 | 4 |
| EPS | A; Ai+1=Ai x (1 + g) | 2.00 | 2.50 | 3.13 | 3.91 | 4.06 |
| Growth rate | g | 25% | 25% | 25% | 4% | |
| Dividend payout ratio | B | 20.00% | 20.00% | 20.00% | 20.00% | 60.00% |
| Required return | C | 10% | ||||
| DPS | D = A x B | 0.50 | 0.63 | 0.78 | 2.44 | |
| Horizon value of DPS at the end of year 4 | E = D4 x (1 + g)/(C - g) | 42.25 | ||||
| PV factor | F = (1 + C)-n | 0.90909091 | 0.826446 | 0.751314801 | 0.683013 | |
| PV of DPS | PV = F x B | 0.45 | 0.52 | 0.59 | 1.66 | |
| PV of Horizon value | G = E x F4 | 28.86 | ||||
| Part (a) Current price of common stock | Sum of all PVs + G | 32.08 |
Part (B) The firm will show the following characteristics in the first three years:
- High growth phase
- Low dividend payout ratio
- High reinvestment phase
These characteristics will disappears from year 4 onward because:
- High growth projects disappear
- Dividend payout increases
- Reinvestment into the company lowers down
- Growth rate decreases
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