Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Tomas was given the following information: -ABC Airlines said its earnings per share is $3 today -the company doesn't pay any dividends, however they plan

Tomas was given the following information:


-ABC Airlines said its earnings per share is $3 today

-the company doesn't pay any dividends, however they plan to pay dividends in the future

-ABC Airlines' earnings grow at 20% per year, for the next five years. The earnings will then slow down to 7% per year for another five years. Finally, the earnings will grow at 2% in perpetuity

-If the first dividend payout is made by distributing 30% of earnings to shareholders after the end of the fifth year, the company will maintain the same payout policy in the future


Tomas was then asked to determine the price of one share of ABC Airlines, assuming the discount rate is 10% (EAR). The following is Tomas's work:


  1. Calculate Future Earnings:
    • Earnings after 5 years = $3 * (1 + 20%)^5 = $3 * 3.2 = $9.60 per share
    • Earnings after 10 years = $9.60 * (1 + 7%)^5 = $9.60 * 1.402551 = $13.44 per share
    • Perpetual earnings = $13.44 * (1 + 2%) / (10% - 2%) = $13.44 * 1.020408 / 0.08 = $168 per share
  2. Calculate Dividends:
    • Dividend in year 6 = 30% * $9.60 = $2.88 per share
  3. Calculate Present Value:
    • Present value of dividend in year 6 = $2.88 / (1 + 10%)^5 = $2.88 / 1.61051 = $1.789 per share
  4. Calculate Terminal Value:
    • Terminal value = Perpetual earnings / (1 + discount rate)^10 = $168 / (1 + 10%)^10 = $168 / 2.593742 = $64.796 per share
  5. Calculate Stock Price:
    • Stock price = Present value of dividend in year 6 + Terminal value = $1.789 + $64.796 = $66.585 per share

So, the price of one share of YQT airlines is approximately $66.59



Required:


-State what Tomas got correct, and what he got incorrect

-State where he went wrong. Did Tomas make any incorrect assumptions or use the wrong equation?

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Financial Reporting And Analysis

Authors: Lawrence Revsine, Daniel Collins, Bruce Johnson, Fred Mittelstaedt, Leonard Soffer

8th Edition

1260247848, 978-1260247848

More Books

Students also viewed these Finance questions