Q4 (22 Marks) A high tech stock just reported an earnings of $3 per share and declared no dividend. The company has 15 million shares outstanding. A talented analyst projects that the company will have a return on new investment of 30% for the first three years and pay no dividend in these three years. The analyst also predicts that after the third year, the company will become mature and its return on new investment will drop to 20%, and it will change its dividend policy by paying out 60% of its earnings forever. To further check his forecast, the analyst also projects that this high tech company will generate free cash flows of $20 million in the next year, and the growth rate of free cash flows is expected to be the same as the growth rate in earnings. The analyst also estimates that the company's beta to be 2. The expected market risk premium is 9% and the risk-free rate is 3%. Currently the firm has $50 million in cash and $800 million in debt. The company's WACC is 14%. Its tax rate is 30%. (a) What is the appropriate discount rate of this stock according to the CAPM? (2 marks) (b) What are the growth rates of the earnings for the company that the analyst is forecasting for the first 3 years, and then from year 3 onward? (3 marks) (c) What is the price of this stock according to the analyst's prediction using the dividend discount model (DDM)? (5 marks) (d) If an investor bought the stock today at the stock price calculated using the DDM in (c), what is the expected capital gain (price appreciation) of holding this stock for one year? (2 marks) (e) The assistant of the analyst argues that the capital gain of holding this stock for one year should equal to the growth rate of earnings for the first year. Comment on whether this argument is correct or wrong. Justify your answer with one reason in one or two sentences. (2 marks) (f) Suppose the high tech firm decides to pay out its dividends one year earlier. Without calculation, holding all else the same, what will be the impact of this decision on the stock price compared to the one calculated in (c)? Explain your answer in one to two sentences. (2 marks) (g) What is the price of this stock according to the analyst's prediction using the discounted free cash flow model? (6 marks) Q4 (22 Marks) A high tech stock just reported an earnings of $3 per share and declared no dividend. The company has 15 million shares outstanding. A talented analyst projects that the company will have a return on new investment of 30% for the first three years and pay no dividend in these three years. The analyst also predicts that after the third year, the company will become mature and its return on new investment will drop to 20%, and it will change its dividend policy by paying out 60% of its earnings forever. To further check his forecast, the analyst also projects that this high tech company will generate free cash flows of $20 million in the next year, and the growth rate of free cash flows is expected to be the same as the growth rate in earnings. The analyst also estimates that the company's beta to be 2. The expected market risk premium is 9% and the risk-free rate is 3%. Currently the firm has $50 million in cash and $800 million in debt. The company's WACC is 14%. Its tax rate is 30%. (a) What is the appropriate discount rate of this stock according to the CAPM? (2 marks) (b) What are the growth rates of the earnings for the company that the analyst is forecasting for the first 3 years, and then from year 3 onward? (3 marks) (c) What is the price of this stock according to the analyst's prediction using the dividend discount model (DDM)? (5 marks) (d) If an investor bought the stock today at the stock price calculated using the DDM in (c), what is the expected capital gain (price appreciation) of holding this stock for one year? (2 marks) (e) The assistant of the analyst argues that the capital gain of holding this stock for one year should equal to the growth rate of earnings for the first year. Comment on whether this argument is correct or wrong. Justify your answer with one reason in one or two sentences. (2 marks) (f) Suppose the high tech firm decides to pay out its dividends one year earlier. Without calculation, holding all else the same, what will be the impact of this decision on the stock price compared to the one calculated in (c)? Explain your answer in one to two sentences. (2 marks) (g) What is the price of this stock according to the analyst's prediction using the discounted free cash flow model? (6 marks)
