The market consensus is that Analog Electronic Corporation has an ROE = 11% and

Question

The market consensus is that Analog Electronic Corporation has an ROE = 11% and a beta of 2.00. It plans to maintain indefinitely its traditional plowback ratio of 3/5. This year's earnings were $2.4 per share. The annual dividend was just paid. The consensus estimate of the coming year's market return is 16%, and T-bills currently offer a 5% return.

Find the price at which Analog stock should sell. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Suppose your research convinces you Analog will announce momentarily that it will immediately change its plowback ratio to 2/5. Find the intrinsic value of the stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Find the price at which Analog stock should sell. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation / Answer

Growth rate (G) = B * R

Where B= retention ratio i.e. 3/5 =0.6

& R = Return on equity = 11 %

Growth rate = 0.6 * 11 = 6.6% or 0.066

Last year dividend (D0) = Earnings ( 1 - B)

= 2.4 ( 1 - 0.6)

= 0.96

Current year dividend (Including growth) [D1]= 0.96 + 6.6% = 1.02336

Cost of equity (Ke) = Risk free rate of return + Beta ( Market rate of return - Risk free rate of return)

= 5 + 2 (16 - 5)

= 27% or 0.27

a. The price at which Analog stock should sell (P0) = D1 / Ke - G

   = 1.02336 / 0.27 - 0.066

   = 1.02336 / 0.204

   = $ 5.016 (approx)

b) Growth rate (G) = B * R

Where B= retention ratio i.e. 2/5 =0.4

& R = Return on equity = 11 %

Growth rate = 0.4* 11 = 4.4% or 0.044

Last year dividend (D0) = Earnings ( 1 - B)

= 2.4 ( 1 - 0.4)

= 1.44

Current year dividend (Including growth) [D1]= 1.44 + 4.4% = 1.50336

Cost of equity (Ke) = Risk free rate of return + Beta ( Market rate of return - Risk free rate of return)

= 5 + 2 (16 - 5)

= 27% or 0.27

b). Intrinsic value of the stock = D1 / Ke - G

   = 1.50336 / 0.27 - 0.044

   = 1.50336 / 0.226

   = $ 6.6520 (approx)

(Note:- Plowback ratio is also known as retention ratio.)

Conclusion:-

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