The Stambaugh Corporation currently has earnings per share of $9.50. The company
ID: 2744131 • Letter: T
Question
The Stambaugh Corporation currently has earnings per share of $9.50. The company has no growth and pays out all earnings as dividends. It has a new project that will require an investment of $2.05 per share in one year. The project is only a two-year project, and it will increase earnings in the two years following the investment by $2.85 and $3.15, respectively. Investors require a return of 10 percent on Stambaugh stock.
a) What is the value per share of the company’s stock assuming the firm does not undertake the investment opportunity?
b) If the company does undertake the investment, what is the value per share now?
c) The company undertakes the investment. What will the price per share be four years from today?
The Stambaugh Corporation currently has earnings per share of $9.50. The company has no growth and pays out all earnings as dividends. It has a new project that will require an investment of $2.05 per share in one year. The project is only a two-year project, and it will increase earnings in the two years following the investment by $2.85 and $3.15, respectively. Investors require a return of 10 percent on Stambaugh stock.
a) What is the value per share of the company’s stock assuming the firm does not undertake the investment opportunity?
b) If the company does undertake the investment, what is the value per share now?
c) The company undertakes the investment. What will the price per share be four years from today?
Explanation / Answer
a. For a no growth company, The share Price = D1/r where D1 =dividend nexy year = 9.50 and Ke = 10% =0.1, hence the share price if the investment is not taken into consideration is 9.50/.1 = $95/share
b. If the company does take this investment the dividends will be :
D1 = 9.50 -2.05 = 7.45
D2 = 9.5 + 2.85 = 12.35
D3 = 9.5 + 3.15 = 12.65
D4 = 9.5
Price in year 3 = D4/r = 9.5/0.1 =95
Hence current price = 7.45/1.10 + 12.35/1.10^2 + 12.65/1.10^3 + 95/1.10^3 = 97.8584 = 97.86
Hence value per share now if investment is undertaken = 97.86
c. Since the investment has returns only for 2 years, the price four years from today will be back to $95.
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