Question 4 Suppose that the consensus forecast of security analysts of your favorite company is that earnings 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 $50.00 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 $50.00 per share imply about the market’s estimate of the company’s growth rate?

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Asked Feb 22, 2019
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Question 4 

Suppose that the consensus forecast of security analysts of your favorite company is that earnings 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 $50.00 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 $50.00 per share imply about the market’s estimate of the company’s growth rate?

 

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Expert Answer

Step 1

a)

Calculation of Equilibrium Price of the Stock:

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Step 2

b)

The equilibrium price of stock will be lower if the required rate of return is higher. Alternatively, the higher the stock price, the higher the growth rate.

(i) With an equilibrium price of $50 per share, the dividend return will be 5% ($2.5/$50) which is nothing but the current earnings divided by the current equilibrium price. The required rate of return will be 13% (8%+5%) which is nothing but the growth rate added with the dividend return. As a result, there will an increase in the required rate of return by 3% (13%-10%). Therefore the required rate of return (13%) is greater than the actual return (10%).  

or

(ii) The growth rate is less than the actual growth rate.

Step 3

c)

Calculation of Growth Rate of the Compa...

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