Question

Summit Systems has an equity cost of capital of 11.0 %​, will pay a dividend of ​$1.50 in one​ year, and its dividends had been expected to grow by 6.0 % per year. You read in the paper that Summit Systems has revised its growth prospects and now expects its dividends to grow at a rate of 3.0 % per year forever.
A. What is the new value of a share of Summit Systems stock based on this information?
B. If you tried to sell your Summit Systems stock after reading this news, what price would you be likely to get? Why?

Answer 1

Answer:

A) The new value of a share of Summit Systems stock based on this information is $17.65

B) $17.65. This is due to the fact that If the information about Summit Systems has reached the capital market, the revised growth rate has already been  applied.

Explanation:

Given:

Equity cost of capital = 11.0 %​

Dividend in one​ year = ​$1.50

Dividends growth per year = 6.0 %

A) If expected growth rate is 6.0%:

Value of share = Expected dividend ÷ (Cost of capital - Growth rate)

Value of share = $1.50 ÷ (0.1150 - 0.060)

Value of share = $27.27

If expected growth rate is 3.0%:

New_Value of share = Expected dividend ÷ (Cost of capital - Growth rate)

New_Value of share = $1.50 ÷ (0.1150 - 0.030)

New_Value of share = $17.65