Textbook Problem

NONCONSTANT GROWTH Assume that it is now January 1, 2017. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As a result, WME is expected to experience a 15% annual growth rate for the next 5 years. Other firms will have developed comparable technology by the end of 5 years, and WME’s growth rate will slow to 5% per year indefinitely. Stockholders require a return of 12% on WME’s stock. The most recent annual dividend which was paid yesterday, was $1.75 per share.

1. a. Calculate WME’s expected dividends for 2017, 2018, 2019, 2020, and 2021.
2. b. Calculate the value of the stock today, ${\hat{\text{P}}}_{\text{0}}$. Proceed by finding the present value of the dividends expected at the end of 2017, 2018, 2019, 2020, and 2021 plus the present value of the stock price that should exist at the end of 2021. The year end 2021 stock price can be found by using the constant growth equation. Notice that to find the December 31, 2021, price, you must use the dividend expected in 2022, which is 5% greater than the 2021 dividend.
3. c. Calculate the expected dividend yield (D₁/P₀), capital gains yield, and total return (dividend yield plus capital gains yield) expected for 2017. (Assume that ${\hat{\text{P}}}_{\text{0}}{\text{=P}}_0$ and recognize that the capital gains yield is equal to the total return minus the dividend yield.) Then calculate these same three yields for 2022.
4. d. How might an investor’s tax situation affect his or her decision to purchase stocks of companies in the early stages of their lives, when they are growing rapidly, versus stocks of older, more mature firms? When does WME’s stock become “mature” for purposes of this question?
5. e. Suppose your boss tells you she believes that WME’s annual growth rate will be only 12% during the next 5 years and that the firm’s long-run growth rate will be only 4%. Without doing any calculations, what general effect would these growth rate changes have on the price of WME’s stock?
6. f. Suppose your boss also tells you that she regards WME as being quite risky and that she believes the required rate of return should be 14%, not 12%. Without doing any calculations, determine how the higher required rate of return would affect the price of the stock, the capital gains yield, and the dividend yield. Again, assume that the long-run growth rate is 4%.