Atrial Pacemakers Incorporated (API) plans to retain 80 percent of earnings to r

Question

Atrial Pacemakers Incorporated (API) plans to retain 80 percent of earnings to reinvest at a

ROE of 30 percent at the end of each of the next two years. At this time, the development of

new products by API's competitors is expected to reduce the return on equity for new

investment ROE for API to 25 percent. Given that API's opportunity cost of capital is 20

percent, the firm is expected to respond by reducing the retention rate to 60 percent of

earnings. Assuming the consensus of Wall Street security analysts that API will report

earnings of $3.00 per share next year (in exactly one year), determine the appropriate price

for API's stock.

Explanation / Answer

As per DDM, stock price is the sum of all future cash flows.

growth rate = retention rate*ROE

1st 2 years, growth rate (G1) = 0.80*30% = 24%

after 2 years, growth rate (G2)= 0.60*25% = 15%

So this problem is essentially a 2 stage DDM model problem.

D1 = EPS * (1- retention rate) = 3*0.20 = 0.60
D2 = D1 * growth rate = 0.60*1.24 = 0.744
D3 = D2*growth rate = 0.744 * 1.15 = 0.8556
r = cost of capital = 20%

Value of stock = D1/(1+r) + D2/(1+r)^2 + D3/(r-G2)
=0.60/1.20 + 0.744/(1.20^2) + 0.8556/(0.20-0.15)
= 0.5 + 0.5167 + 17.112 = $18.13

Thus the appropriate value of the stock is $18.13

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.