Question

Newman Manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned $4.02 per share and paid cash dividends of $2.32 per share (D=$2.32). Grips' earnings and dividends are expected to grow at 30% per year for the next three years, after which they are expected to grow at 6% per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of 14% on investments with risk characteristics similar to those of Grips? The maximum price per share that Newman should pay for Grips is $ (Round to the nearest cent.)

Answer 1

Newman Manufacturing should use the Gordon Growth Model to calculate the present value of expected future dividends that are growing at varying rates. The calculation includes finding the dividends for the first three years and the price at the end of the third year using the constant growth formula, then discounting them back to present value. The maximum price per share that Newman should pay for Grips is approximately $34.41.

Step-by-step explanation:

To calculate the maximum price per share that Newman Manufacturing should pay for Grips Tool, we will use the Gordon Growth Model which considers the present value of the expected future dividends. Since Grips Tool's dividends are expected to grow at a rate of 30% for the next three years and then 6% to infinity, we can calculate the dividends for the first three years and then use the constant growth formula to find the price at the end of year three. Finally, we discount these future dividends back to the present value at the required return rate of 14%.

Here's the calculation for the dividends in the first three years:

• D1 = $2.32 * (1 + 0.30) = $3.016
• D2 = $2.32 * (1 + 0.30)^2 = $3.9208
• D3 = $2.32 * (1 + 0.30)^3 = $5.09704

The price at the end of the third year (P3) can be calculated using the constant growth formula:

P3 = D3 * (1 + long-term growth rate) / (required return - long-term growth rate)

P3 = $5.09704 * (1 + 0.06) / (0.14 - 0.06)

P3 = $37.48

We then discount D1, D2, D3, and P3 back to the present value:

P0 = (D1 / (1 + 0.14)) + (D2 / (1 + 0.14)^2) + (D3 / (1 + 0.14)^3) + (P3 / (1 + 0.14)^3)

P0 = $3.016 / 1.14 + $3.9208 / 1.2996 + $5.09704 / 1.481544 + $37.48 / 1.481544

P0 = $2.64561 + $3.01727 + $3.43970 + $25.30858

P0 = $34.41116

Therefore, the maximum price per share that Newman Manufacturing should pay for Grips is approximately $34.41.