Erica is analyzing the shares of songatikamascompany. the company currently pays a dividend of $2.50. she believes the company has a new product that will result in supernormal growth of 20% for two years

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erica is analyzing the shares of songatikamascompany. the company currently pays a dividend of $2.50. she believes the company has a new product that will result in supernormal growth of 20% for two years. once the market for this product is saturated, she expects the songatikamas? growth will fall to 3%, which is equal to the level of world economic growth. erica determines that the required return on songatikamasshould be 12%. what is the value of songatikamas? shares?

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LectureNotes said Erica is analyzing the shares of Songatikamas Company. The company currently pays a dividend of $2.50. She believes the company has a new product that will result in supernormal growth of 20% for two years. Once the market for this product is saturated, she expects the Songatikamas’ growth will fall to 3%, which is equal to the level of world economic growth. Erica determines that the required return on Songatikamas should be 12%. What is the value of Songatikamas’ shares?

Answer:

To determine the value of Songatikamas’ shares, we can use the Dividend Discount Model (DDM), specifically the two-stage growth model, because the company is expected to have supernormal growth for a period followed by a stable growth phase.

Here’s how we can calculate it step-by-step:

  1. Calculate the dividends for the supernormal growth period:

    • Year 1:
      D_1 = D_0 \times (1 + g_1) = 2.50 \times (1 + 0.20) = 2.50 \times 1.20 = 3.00
    • Year 2:
      D_2 = D_1 \times (1 + g_1) = 3.00 \times (1 + 0.20) = 3.00 \times 1.20 = 3.60

  2. Calculate the dividend at the start of the stable growth period (Year 3):

    • Year 3:
      D_3 = D_2 \times (1 + g_2) = 3.60 \times (1 + 0.03) = 3.60 \times 1.03 = 3.708

  3. Calculate the present value of dividends during the supernormal growth period:

    • Present Value of Dividends:
      PV(D_1) = \frac{D_1}{(1 + r)^1} = \frac{3.00}{(1 + 0.12)^1} = \frac{3.00}{1.12} = 2.68
      PV(D_2) = \frac{D_2}{(1 + r)^2} = \frac{3.60}{(1 + 0.12)^2} = \frac{3.60}{1.2544} = 2.87

  4. Calculate the terminal value at the end of the supernormal growth period and its present value:

    • Terminal Value (TV) at Year 2:
      TV = \frac{D_3}{r - g_2} = \frac{3.708}{0.12 - 0.03} = \frac{3.708}{0.09} = 41.20
    • Present Value of Terminal Value:
      PV(TV) = \frac{TV}{(1 + r)^2} = \frac{41.20}{(1.12)^2} = \frac{41.20}{1.2544} = 32.85

  5. Calculate the total present value of the stock:

    • Total Present Value:
      PV_{\text{total}} = PV(D_1) + PV(D_2) + PV(TV) = 2.68 + 2.87 + 32.85 = 38.40

Therefore, the value of Songatikamas’ shares, according to Erica’s analysis, is approximately $38.40.