1. suppose that the consensus forecast of security analysts of your favorite com
ID: 2663755 • Letter: 1
Question
1. suppose that the consensus forecast of security analysts of your favorite company is that earning next year will be E1 = $5.00 per share. suppose that the company tends to plow back 50% of its earnings and pay the rest as dividends. if the chief financial officer (CFO) estimates that the company's growth rate will be 8% from now onwards, answer the following questions.a) if your estimate of the company's required rate of return on its stock is 10%, what is the equilibrium price of the stock?
b) suppose you observe that the stock is selling for $50 per share, and that this is the best estimate of its equilibrium price. what would you conclude about either (i) your estimate of the stock's required rate of return, or (ii) the CFO's estimate of the company's future growth rate?
c) suppose your own 10% estimate of the stock's required rate of return is shared by the rest of the market. what does the market price of $50 per share imply about the market's estimate of the company's growth rate?
Explanation / Answer
earning per share = $ 5 dividend payout = 50%, so, dividend = $ 2.5 dividend growth = 8% expected return = 10% a) return required from dividend = expected return - growth rate = 10 - 8 = 2% . equilibrium price = dividend/return on dividend = 2.5 / 0.02 = 125 ($) (ANSWER) b) If equilibrium price = 50 ($), return from dividend = 2.5/50 = .05 = 5% i) so, required rate of return = 5+ 8 (growth rate) = 13% i.e. estimate is lower by 3%. or ii) growth rate = 10 - 5 = 5% i.e. growth is overestimated by 3%. (ANSWER) c) as shown in part b)ii) above, market's estimate of growth rate is 5% (ANSWER)
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