It is hard, but if you get it right, you will get 2 bonus points added to your t

Question

It is hard, but if you get it right, you will get 2 bonus points added to your total points for the course. Haljjford Corporation expects to have earnings this coming year of $3 per share. Haljifor^plans to retains all of its earnings for the next 2 years. For the subsequent two years, the firm will retain 50% of its earnings. It will then retain 20% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 25% per year. Any earnings that are not retained will be paid out as dividends. Assume HaUifetd.'? share count remains constant and all earnings growth comes from the investment of retained earnings. If JMj/ftKJL'S equity cost of capital is 10%, what price would you estimate for Halliford stock?

Explanation / Answer

From year 5 on, dividends grow at constant rate of 5%.

Therefore, P(4) = 4.75/(10% – 5%) =$95.

Then P(0) = 2.34 / 1.103 + (2.64 + 95) / 1.104 = $68.45.  

Year 1 2 3 4 5 6 Earnings 25% 25% 12.50% 12.50% 5% 1. EPS Growth rate (vs. prior yr) $3.00 $3.75 $4.69 $5.27 $5.93 $6.23 2 EPS Dividends 3. Retention ratio 100% 100% 50% 50% 20% 20% 4. Dividend payout ratio 0% 0% 50% 50% 80% 80% 5. Div (2*4) $2.34 $2.64 $4.75 $4.98

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