P 10-19 (similar to) -Question Help * Summit Systems has an equity cost of capit

Question

P 10-19 (similar to) -Question Help * Summit Systems has an equity cost of capital of 12.0%, will pay a dividend of $1.25 in one year, and its dividends had been expected to grow by 7.0% per year. You read in the paper that Summit Systems has revised its growth prospects and now expects its dividends to grow at a rate of 3.5% per year forever. a. What is the drop in value of a share of Summit Systems stock based on this information? b. If you tried to sell your Summit Systems stock after reading this news, what price would you be likely to get? Why? a. What is the drop in value of a share of Summit Systems stock based on this information? The drop in value of a share of Summit Systems stock is $11.22. (Round to the nearest cent.)

Explanation / Answer

a) Equity cost of capital = 12%

dividend paid in>

Expected Growth = 7% per year

As per Gordan growth model price of stock after 1 year = dividend after 1 year*(1+g)/(r-g), where g is growth and r is equity cost of capital

So price of stock after 1 year = 1.25*(1+0.07)/(0.12-0.07) = $26.75

Current price of stock is present value of stock

Present value = Price of stock after 1 year / (1+r) = 26.75/1.12 = $23.88

If dividend is expected to grow at 3.5%

Then price of stock after 1 year = 1.25*(1+0.035)/(0.12-0.035) = $15.22

Present value = Price of stock after 1 year / (1+r) = 15.22/1.12 = $13.59

If expected growth of dividend is declined from 7% to 3.5% the value of stock drops by 23.88-13.59 = $10.29

b) After reading the news of decline in expected dividend growth to 3.5% the value of stock = $13.59 (calculation performed above)

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