Chiptech, 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 the company plans to maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects this situation to persist indefinitely.
a.What is the market price of Chiptech stock? The required return for the company chip industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t=1).
b. Suppose you discover that Chiptechs competitor has developed a new chip that will eliminate Chiptechs current technological advantage in this market. This new product, which will be ready to come to the market in 2 years, will force Chiptech to reduce its
prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for this product, Chiptech will decrease the plow bank ratio to 0.40. The plow bank 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 years earnings. What is your estimate of Chiptechs intrinsic value per share? (Hint: carefully prepare a table of Chiptechs earnings and dividends for each of the next 03 years. Pay close attention to the change in the payout ratio in t=2)
c. No one else in the market perceives the thread to Chiptechs market. In fact, you are confident that no one else will become aware of the change in Chiptechs competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t=0 and t=1)? In the second year (between t=1and t=2)? In the third year (between t=2 and t=3)? (Hint: pay attention to when the market catches on to the new situation. A table of dividend and market prices over time might help).