Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends

Question

Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 8% per year.

If r = 12% and DIV1 = $5, what is the price of a share? (Do not round intermediate calculations.)

What price do you forecast for the stock one year from now? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

What is the cost of capital on the stock? (Do not round intermediate calculations.)

Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 8% per year.

Explanation / Answer

g = -8%

a. Price of a share = D1/(r - g) = 5 / [0.12 - (-0.08)] = 5/(0.12+0.08) = 5/0.20 = $25 per share

b. D2 = 5 x (1 - 0.08) = $4.60 per share
Price of share one year from now = 4.6/(0.12+0.08) = $23 per share

c. Cost of capital = D1/P0 + g = 5/25 - 0.08 = 0.12 or 12% = r (given)

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