Question
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:
- 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
- Calculate Dividends:
- Dividend in year 6 = 30% * $9.60 = $2.88 per share
- Calculate Present Value:
- Present value of dividend in year 6 = $2.88 / (1 + 10%)^5 = $2.88 / 1.61051 = $1.789 per share
- Calculate Terminal Value:
- Terminal value = Perpetual earnings / (1 + discount rate)^10 = $168 / (1 + 10%)^10 = $168 / 2.593742 = $64.796 per share
- 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?
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