Question

Mylex Inc has just released an improved version of its popular sporting product and the world is beating a path to its door. As a result, the firm projects growth of 25% per year for the next five years. Competition in the product market is expected to drive down profit margins, and hence the sustainable growth rate will fall to 5% after five years. The most recent (i.e. year 0) earnings were $4 per share. The firm has a dividend payout ratio of 25% and its discount rate is 10%. i) What is the value of the stock price today? ii) What is the expected stock price five years from now? iii) If you buy the stock today and hold it for one year, at what price can you sell the stock? iv) If you buy the stock now and sell it in 1 year, what will be your rate of return?

Answer 1

The value of the stock price today for Mylex Inc can be estimated using the dividend discount model by calculating the present value of future dividends. The stock price in five years can be calculated as the terminal value using the model. To determine the selling price after one year and the rate of return, dividends, and stock price appreciation are considered.

Step-by-step explanation:

Valuation of Mylex Inc's Stock

To determine the value of the stock price today for Mylex Inc, we need to calculate the present value of all future dividends. Given the expected growth rates, dividend payout ratio, and the discount rate, we can use the dividend discount model (DDM) for valuation. The dividends are expected to grow at 25% for the next five years and at 5% thereafter. The most recent earnings were $4 per share, and with a dividend payout ratio of 25%, the initial dividend would be $1 per share.

For the first part of the question, we calculate the present value of dividends for the first five years considering a 25% growth, and then use the Gordon Growth Model to find the terminal value at the end of five years, which is then discounted back to today. The stock price value today can be calculated as the sum of these present values.

For the second part, we project the stock price five years from now, which would be the terminal value calculated before, but without discounting it back to the present value, as we're considering it at that future time point.

For parts three and four, we determine the stock price in one year and calculate the expected rate of return, which would include the dividend received after one year and the capital gains from the change in stock price.