The maximum price per share that Newman should pay for Grips is ?

Question

Newman Manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just​ completed, Grips earned ​$3.88 per share and paid cash dividends of ​$2.18 per share ​(D0=$2.18​). Grips' earnings and dividends are expected to grow at 40​% per year for the next 3​ years, after which they are expected to grow 6​% per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of 14​% on investments with risk characteristics similar to those of​ Grips?

Answer 1

Step one: Forecast the dividends beyond the 3 year growth horizon (thats all we need to solve the problem). Start with D1 and then multiply that by 1.4 for the first three years, and then 1.06 for the final period.

Do = 2.18, D1 = 3.052, D2 = 4.2728, D3 = 5.9812, D4 = 6.34

Step Two: Use the Discount Dividend Model, or the Gordon Growth Model to calculate the terminal value of the stock after the regular growth period has begun. Use the following formula:

Po = D1 / (R-g)

Where: Po is stock price today

D1 = Next dividend

R = Required return on the stock, and

g = Growth rate

79.25 = 6.34 / (0.14 - 0.06) --> This is the value not today, but at t = 3, so discount this 3 years along with the final dividend from the 40% growth period.

Step Three: Calculate the stock value today by adding together all the expected dividends and the terminal value, and then discounting each cash flow appropriately.

Po = 3.052/(1.14) + 4.2728/(1.14)^2 + 5.9812/(1.14)^3 + 79.25/(1.14)^3

You can also put these in your CF function if you have a BAII or similar finance calculator, that will be the quickest way!

The answer is $63.49