Question

Summit Systems has an equity cost of capital of 11.5 %​, will pay a dividend of ​$1.50 in one​ year, and its dividends had been expected to grow by 5.5 % 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 2.5 % per year forever. a. What is the drop in 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.

If expected growth rate is 5.50%:

Value of share = Expected dividend / (Cost of capital - Growth rate)
Value of share = $1.50 / (0.1150 - 0.0550)
Value of share = $25.00

If expected growth rate is 2.50%:

Value of share = Expected dividend / (Cost of capital - Growth rate)
Value of share = $1.50 / (0.1150 - 0.0250)
Value of share = $16.67

So, value of share will drop by $8.33 ($25.00 - $16.67) based on the information.

Answer b.

If the information about Summit Systems has reached the capital market which means that revised growth rate has been already applied. So, if you sell the stock, then you will receive $16.67