Nortel Network Solutions (NNS) is a growth company. In the most recently complet

Question

Nortel Network Solutions (NNS) is a growth company. In the most recently completed fiscal year (Year 0), they earned $8.00 per share and paid out $2.00 per share in dividends. For the next five years, both earnings and dividends will grow by 20% percent per year. After that, you predict the dividends will grow by only 5%, forever, at a constant rate. If you require at least a 12% return on growth stocks, what is the value of a share of NNS today? Now Compute the value of NNS shares, but instead of using constant growth, assume that at the end of year five the stock price will be equal to 10 times earnings (that is, assume the trailing P/E at the end of year 5 is 10).

Please show and clearly explain work!

Explanation / Answer

Price under constant growth model:

Price = Present value of dividend + Present value of terminal value at end of year 6

= 2*1.20/1.12 + 2*1.20^2/1.12^2 + 2*1.20^3/1.12^3 + 2*1.20^4/1.12^4 + 2*1.20^5/1.12^5 + 2*1.20^5*1.05/(.12-.05)/1.12^5

= 54.72

Price under trailing PE:

Price = Present value of dividend + Present value of terminal value at end of year 6

= 2*1.20/1.12 + 2*1.20^2/1.12^2 + 2*1.20^3/1.12^3 + 2*1.20^4/1.12^4 + 2*1.20^5/1.12^5 + 2*1.20^5*1.05*10/1.12^5

= 42.01

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