Common stock valuelong dash—Variable growthNewman manufacturing is considering a

Question

Common stock

valuelong dash—Variable

growthNewman manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned

$3.63

per share and paid cash dividends of

$1.93

per share

(D0equals=$1.93).

Grips' earnings and dividends are expected to grow at

40%

per year for the next 3 years, after which they are expected to grow

7%

per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of

11%

on investments with risk characteristics similar to those of Grips?

Explanation / Answer

Value of the Stock = Present Value of Dividends+ Present Value of Price at the 7th Year

= $ 9.376770635+ $ 103.5848559

= $ 112.96

Note :

Present Value of Dividends=

Value of Price at the 3rd Year= Dividend In Year 4/ ( Required Rate of Return - Growth rate)

= ( $ 5.29592* 107%) / (11% -7%)

= $ 141.66586

Present Value of Price at the 7th Year=Value of Price at the 7th Year *  Present Value of Discounting Factor(14%,7)

= $ 141.66586*0.731191381

= $ 103.5848559

Year Dividend Discounting Factor (11%) Present Value ( Dividend * Discounting factor) 1 2.702 0.900900901 2.434234234 2 3.7828 0.811622433 3.07020534 3 5.29592 0.731191381 3.87233106 Present Value of Dividends 9.376770635

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