Inteluck Inc is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned $1 a share last year and just paid out a dividend of $0.50 per share. Investors believe that the company plans to maintain its dividend payout at 50%. ROE stands at 20%. Everyone in the market expects this situation to persist indefinitely.
a. What is the market price of Inteluck stock? The required return for Inteluck is 15% and the company has just gone ex-dividend (ie the next dividend will be paid a year from now, at t=1).
b. Suppose you discover that Inteluck’s competitor has developed a new chip that will eliminate Inteluck’s current technological advantage in this market. This new product, which will be ready to come to the market in two year, will force Inteluck to reduce the prices of its chips to remain competitive. This will decrease the ROE to 15% and, because of falling demand for its product, Inteluck will decrease its plowback ratio to 0.40. The plowback ratio will be decreased at the end of the second year, at t=2: the annual year-end dividend for the second year (paid at t=2) will be 60% of that year’s earnings. What is your estimate of Inteluck’s intrinsic value per share? (Hint: Carefully prepare a table of Inteluck’s earnings and dividends for each of the next three years. Pay close attention to the change in payout ratio in t=2)
c. No one else in the market perceives the threat to Inteluck’s market. In fact, you are confident that no one else will become aware of the change in Inteluck’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will the rate of return on Inteluck stock in coming year (ie between t=0 and t=1)? In the second year (between t=1 and t=2)? The third year (between t=2 and t=3)? (Hint: Pay attention to when the market catches on the new situation. A table of dividends and market prices over time might help.)