Question

Benchmark​ Metrics, Inc.​ (BMI), an​ all-equity financed​ firm, reported EPS of $4.66 in 2008. Despite the economic​ downturn, BMI is confident regarding its current investment opportunities. But due to the financial​ crisis, BMI does not wish to fund these investments externally. The Board has therefore decided to suspend its stock repurchase plan and cut its dividend to $0.98 per share​ (vs. almost $2 per share in​ 2007), and retain these funds instead. The firm has just paid the 2008​ dividend, and BMI plans to keep its dividend at $0.98 per share in 2009 as well. In subsequent​ years, it expects its growth opportunities to​ slow, and it will still be able to fund its growth internally with a target 35% dividend payout​ ratio, and reinitiating its stock repurchase plan for a total payout rate of 63%. ​(All dividends and repurchases occur at the end of each​ year.)

Suppose​ BMI's existing operations will continue to generate the current level of earnings per share in the future. Assume further that the return on new investment is 15%​, and that reinvestments will account for all future earnings growth​ (if any).​ Finally, assume​ BMI's equity cost of capital is 10%.
a. Estimate​ BMI's EPS in 2009 and 2010​ (before any share​ repurchases).
b. What is the value of a share of BMI at the start of 2009​ (end of​ 2008)?
Hint​: Make sure to round all intermediate calculations to at least four decimal places.​

Answer 1

a. Estimate BMI's EPS in 2009 and 2010 (before any share repurchases).

To estimate BMI's EPS in 2009, we'll use the given information that the firm's existing operations will continue to generate the current level of earnings per share in the future. Therefore, the EPS in 2009 will be the same as in 2008, which is $4.66.

In 2010, the EPS will grow due to the reinvestment of retained earnings. We're told that the return on new investment is 15%, and all future earnings growth will be accounted for by reinvestments.

The retained earnings for the year 2009 can be calculated as follows:
Retained Earnings (2009) = EPS (2009) – Dividend (2009)
= $4.66 - $0.98
= $3.68

The growth in EPS for 2010 due to this reinvestment will be:
EPS growth (2010) = Retained Earnings (2009) * Return on new investment
= $3.68 * 15%
= $0.552

Therefore, the EPS in 2010 would be:
EPS (2010) = EPS (2009) + EPS growth (2010)
= $4.66 + $0.552
= $5.212

b. What is the value of a share of BMI at the start of 2009 (end of 2008)?

The value of a share of BMI at the start of 2009 can be estimated by discounting the future dividends and repurchases to the present. However, the repurchase plan is suspended for the year 2009 and will be reinitiated in 2010. So, for the year 2009, we only consider the dividend.

For the year 2009:
Dividend (2009) / (Equity cost of capital)
= $0.98 / 0.10
= $9.8

From 2010 onwards, the firm plans to pay out 63% of its earnings in dividends and repurchases. As with a stable growth dividend discount model, we calculate the value of these future payouts at the end of 2009 as follows:

EPS (2010) * Total payout ratio / (Equity cost of capital – Growth rate)
= $5.212 * 0.63 / (0.10 - 0.15)
= $34.4116

Therefore, the value of a share at the start of 2009 (end of 2008) would be the sum of these two components (The dividend for the year 2009 and the discounted value of future dividends and repurchases):

Value of share = Value of dividend (2009) + Value of future dividends and repurchases
= $9.8 + $34.4116
= $44.2116

So, the value of a share of BMI at the start of 2009 (end of 2008) would be approximately $44.2116.