Rite Bite Enterprises sells toothpicks. Gross revenues last year were

QUESTION

Rite Bite Enterprises sells toothpicks. Gross revenues last year were
$3 million, and total costs were $1.5 million. Rite Bite has 1 million shares of common stock
outstanding. Gross revenues and costs are expected to grow at 5 percent per year. Rite Bite
pays no income taxes. All earnings are paid out as dividends.
a. If the appropriate discount rate is 15 percent and all cash flows are received at years end,
what is the price per share of Rite Bite stock?
b. Rite Bite has decided to produce toothbrushes. The project requires an immediate outlay
of $15 million. In one year, another outlay of $5 million will be needed. The year
after that, earnings will increase by $6 million. That profit level will be maintained in
perpetuity. What effect will undertaking this project have on the price per share of the
stock?
Answer A Discount rate 15% Price per share = Next years dividend/Discount rate less growth rate Price per share =1.575/15% less 5% Price per share =$ 15.75 Next years dividend Gross Revenues 3 million less: Total Costs 1.5 million Earnings 1.5 million Earnings 1.5 million add: growth 0.075 million Next years Dividend amount 1.575 million Answer B Net Present Value of Growth Opportunities Cash outflow Year Cash flow Discount factor @ 15% Discounted¦

Amount 0 (15) 1 (15.00) 1 (5) 0.870 (4.35) 2 nd year onwards 6 34.78 Total 15.43 Price per share = 15.43 million/1 million Price per share = $ 15.43 Thepriceincreasesby$15.43pershare. Cash Inflow of Earnings $ 6 million each year Cash inflow/15% /(1+discount rate) 6 million/0.15/(1+15%) 34.782 million

ANSWER:

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