Highland Pet Supplies Company forecasts earnings per share of $2.50 during the coming year. Highland has always paid a dividend equal to 40 percent of its earnings, and it anticipates continuing this practice. Earnings are expected to increase at a rate of 30 percent per year in years 2 and 3, 26 percent in year 4, and 19 percent per year thereafter. The beta of Highland stock is 1.3, the risk-free rate is 5 percent, and the market risk premium has been estimated to be 10 percent. Use Table II to answer the questions below. Round your answers for the questions below to the nearest cent.

1. What is the current (time 0) value of a share of Highland stock?
2. $ 
3.  
4. What value would you project for a share of stock at the beginning of year 3?
5. $ 

 

What is the current (time 0) value of a share of Highland stock?

= - $150.32

And Price 3 years from now

= $2.534 - $214.75

= -$212.22

We should not buy this stock as growth rate is more than the required rate of return.

Step-by-step explanation

Given,

Highland Pet Supplies Company forecasts earnings per share of $2.50 during the coming year.

i.e. Expected EPS at Year 1 (EPS₁) = $2.5

Highland has always paid a dividend equal to 40 percent of its earnings

and it anticipates continuing this practice.

So, Dividend payout ratio = 40%

So, Expected Dividend at Year 1

D₁ = $2.5*40%

D₁ = $1

Earnings are expected to increase at a rate of 30 percent per year in years 2 and 3,

26% in year 4,

and 19 percent per year thereafter.

The beta of Highland stock is 1.3, the risk-free rate is 5 percent, and the market risk premium has been estimated to be 10 percent.

So, required rate of return (Re)

= Rf + (MRP) * B

Where,

Rf is Risk Free Return i.e. 5%

MRP is Market Risk Premium = 10%

Beta = 1.3

So,

Re = 5% + 10% * 1.3

= 5% + 13%

= 18%

Stage 1 :-

Period till 4 years-

D₁ = $1.00

D₂ = $1.00 * 130%

= $1.30

D₃ = $1.30 * 130%

= $1.69

D₄ = $1.69 * 126%

= $2.1294

D₅ = $2.1294 * 119%

= $2.534

 

So, Present Value at Year 4

P₄ = D_5/(Re - g)

= $2.534 / (0.18-0.19)

= -$253.40 (Negative)

 

PV today = -$253.40/(1.18)³

= -$154.23

 

 

Since growth rate is higher than required rate, share price will be negative

 

= $3.91 - $154.23

= -$150.32

 

What is the current (time 0) value of a share of Highland stock?

 

= - $150.32

(We should not buy the shares)

 

What value would you project for a share of stock at the beginning of year 3?

 

It will be present value of dividends from year 4 onwards

 

PV OF D4 = $2.1294 / 1.18

= $1.8046

 

D5 = $2.1294 * 119%

= $2.534

 

Pv at 4 years from now = -$253.40

 

Pv at 3 years from now

= -$214.75/1.18

= -$214.75

 

So, Price 3 years from now

= $2.534 - $214.75

= -$212.22

Please see the attached file for the complete solution