Common stock value-Variable Growth-Newman Manufacturing is Considering a cash pu

Question

Common stock value-Variable Growth-Newman Manufacturing is Considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned $3.86 per share and paid cash dividends of $2.16 per share (Do = $2.16) Grips earnings and dividends are expected to grow at 40% per year for the next 3 yrs. after which they are expected to grow 9% per year till infinity. What is the maximum price per share that Newman should pay for Grips if it had a required return of 12% on investments with risk characteristics similar to those of Grips. Round answer to the nearest cent.

Explanation / Answer

We use DCF model Here we have G1=40% for 3 Yrs & then g=9% from Y4 onwards Ks=12%, DO=2.16 We have D0=2.16 D1= D0*(1+G1) = 2.16*(1+40%) = $3.02 D2=D1*(1+40%) = 3.02*(1+40%) = $4.23 D3 = D2*(1+40%) = $4.23*(1+40%) = $5.92 D4 = D3*(1+9%) = $5.92*(1+9%) = $5.45 SO Horizon Value P3 = D4/(Ks-g) = $5.45/(12%-9%) = $181.67 So Share price P0 = D0+D1/(1+Ks)^1 +D2/(1+Ks)^2 + D3/(1+Ks)^3 +PV of Horizon value P3 Ie P0 = 2.16 + 3.02/(1+12%)^1 + 4.23/(1+12%)^2 + 5.92/(1+12%)^3 + 181.67/(1+12%)^3 ie P0 = $141.75 So maximum price per share that Newman should pay for Grips is $141.75

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