Suppose that a firm’s recent earnings per share and dividend per share are $3.60

Question

Suppose that a firm’s recent earnings per share and dividend per share are $3.60 and $2.60, respectively. Both are expected to grow at 8 percent. However, the firm’s current P/E ratio of 17 seems high for this growth rate. The P/E ratio is expected to fall to 13 within five years.

a) Compute the dividends over the next five years. (Do not round intermediate calculations and round your final answers to 3 decimal places.)

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

c) Calculate the present value of these cash flows using a 10 percent discount rate. (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Explanation / Answer

a) Dividends over the next 5 years at a growth rate of 8%: Year Dividends 1 2.808 2 3.033 3 3.275 4 3.537 5 3.820 b) Value of the stock in 5 years: Price of the share = EPS*P/E ratio EPS in five years = 3.6*1.08^5= $           5.290 Therefore price after 5 years = 5.290*13 = $68.77 c) PV of the cash flow using 10% discount: Year Dividends pvif $ 10% PV 1 2.808 0.9091 2.55 2 3.033 0.8264 2.51 3 3.275 0.7513 2.46 4 3.537 0.6830 2.42 5 3.820 0.6209 2.37 Price 68.77 0.6209 42.70 PV of the Cash flows     = $ 55.01

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