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The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next five years. Its latest EPS was $10, all of which was reinvested in the company. The firm’s expected ROE for the next five years is 20% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm’s ROE on new investments is expected to fall to 15%, and the company is expected to start paying out 40% of its earnings in cash dividends, which it will continue to do forever after. DEQS’s market capitalization rate is 15% per year. a. What is your estimate of DEQS’s intrinsic value per share? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? (Round your dollar value to 2 decimal places.) Because there is (Click to select) , the entire return must be in (Click to select) . c. What do you expect to happen to price in the following year? (Round your dollar value to 2 decimal places.)

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jepessoa

Answer:

a) $94.88

b)  in 1 year, the intrinsic price of the stocks should increase to $109.11

Explanation:

year                      dividend              EPS

0                              0                       $10

1                               0                       $12

2                              0                       $14.40

3                              0                       $17.28

4                              0                       $20.736

5                              0                       $24.8832

6                              $11.45               $28.61568

growth rate up to year 5 = 20%

ROE growth rate starting year 6 = 15%

dividend growth rate starting year 6 = 15% x (1 - 40%) = 9%

cost of equity = 15%

horizon value at year 5 = $11.45 / (15% - 9%) = $190.83

current intrinsic value per stock = $190.83 / 1.15⁵ = $94.88

intrinsic price in 1 year = $190.83 / 1.15⁴ = $109.11

The estimate of DEQS’s intrinsic value per share is $94.88. Also, in 1 year, the intrinsic price of the stocks will increase to $109.11.

Based on the information given, the dividend and the earnings per share are given below:

year                     dividend             EPS

0                              0                       $10

1                               0                       $12

2                              0                      $14.40

3                              0                       $17.28

4                              0                       $20.736

5                              0                       $24.88

6                              $11.45               $28.616

  • Growth rate up to year 5 = 20%
  • ROE growth rate starting year 6 = 15%
  • Cost of equity = 15%

Therefore, the dividend growth rate starting year 6 will be:

= 15% x (1 - 40%)

= 15% × 60%

= 9%

Therefore, the horizon value at year 5 will be:

= $11.45 / (15% - 9%)

= $11.45 / 6%

= $190.83

Then, the current intrinsic value per stock will be:

= $190.83 / 1.15⁵

= $94.88

The intrinsic price in 1 year will be:

= $190.83 / 1.15⁴

= $109.11

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