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 $4.24 per share and paid cash dividends of $2.54 per share (D0=$2.54). Grips' earnings and dividends are expected to grow at 35% per year for the next 3 years, after which they are expected to grow 8% per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of 16% on investments with risk characteristics similar to those of Grips?

Explanation / Answer

1) Calculation of Maximum price per share :

D1 = $2.54 * 1.35 = $3.429

D2 = $3.429 * 1.35 = $4.63

D3 = $4.63 * 1.35 = $6.25

D4 = $6.25 * 1.08 = $6.75

Terminal value = D4 / (Required return - Growth rate)

= $6.75 / (0.16 - 0.08)

= $84.375

Maximum price per share = ($3.429 / 1.16) + ($4.63 / (1.16)2) + ($6.25 / (1.16)3) + ($84.375 / (1.16)3)

= $2.956 + $3.44 + $4 + $54.06

= $64.45

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