Case 12 Time Value of Money and Firm Valuation Smokestack Te

Case 1.2: Time Value of Money and Firm Valuation

Smokestack Technologies, Inc. (STI), is a company in a declining industry. The company is currently earning profits of $10 per share of common stock, but the company\'s profitability is expected to decline by 10% annually forever. The company intends to fully distribute whatever profits are earned to stockholders annually in the form of dividends, beginning with an immediate payment of $10 per share now and continuing payouts on this date each year from now. The relevant interest rate is 10% annually. A popular investors’ newsletter issues a recommendation to sell STI stock at its current price of $47 per share, based on the argument that the stock\'s value can only go down in the future as its profits decline. Do you agree with the recommendation to sell? Explain.

Solution

required return=10%
growth rate=-10%
Intirnisc Value=Dividend 1 year later/(required return-growth rate)=Dividend now*(1+growth rate)/(required return-growth rate)=10*(1-10%)/(10%-(-10%))=45

As the stock is currnetly valued at 47, which is more than intrincis value, one should sell the stock..Hence, we agree with the recommendation