Suppose that a firm’s recent earnings per share and dividend per share are $3.10

ID: 2736663 • Letter: S

Question

Suppose that a firm’s recent earnings per share and dividend per share are $3.10 and $2.50, respectively. Both are expected to grow at 7 percent. However, the firm’s current P/E ratio of 26 seems high for this growth rate. The P/E ratio is expected to fall to 22 within five years.

Compute the dividends over the next five years.

Compute the value of this stock price in five years. (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Calculate the present value of these cash flows using a 9 percent discount rate. (Do not round intermediate calculations and round your final answer to 2 decimal places.

Dividends Years First year $ Second year $ Third year $ Fourth year $ Fifth year $

Explanation / Answer

Year

Calculation of dividend

Dividend paid

$2.50 x (1+0.07)1

$2.6750

$2.50 x (1+0.07)2

$2.8623

$2.50 x (1+0.07)3

$3.0626

$2.50 x (1+0.07)4

$3.2770

$2.50 x (1+0.07)5

$3.5064

Price of stock in Year 5 = 22 x $3.10 x (1.07)5 = $108

PV of cash flows = {$2.6750/(1+.09)1} + {$2.8632/(1+.09)2} + {$3.0626/(1+.09)3} + {$3.2770/(1+.09)4} + {$3.5064/(1+.09)5} + {$108/(1+.09)5} = $82.02