Chapter 13, Problem 27C

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 $\$\text{1}$ per share last year and just paid out a dividend of $\$0.\text{5}0$ per share. Investors believe the company plans to maintain its dividend payout ratio at $\text{5}0\%$ . ROE equals $\text{2}0\%$ . Everyone in the market expects this situation to persist indefinitely. $\left(\text{LO 13}-\text{2}\right)$
a. What is the market price of Chiptech stock? The required return for the computer chip industry is $\text{15}\%$ , 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 Chiptech’s competitor has developed a new chip that
will eliminate Chiptech’s current technological advantage in this market. This new product, which will be ready to come to the market in two years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to $\text{15}\%$ , and, because of falling demand for its product, Chiptech will decrease the plowback ratio to $0.\text{4}0$ . The plowback ratio will be decreased at the end of the second year, at $t=2:$ The animal year-end dividend for the second year (paid at $t=2$ ) will be $\text{6}0\%$ of that year’s earnings. What is your estimate of Chiptech‘s intrinsic value per share? (Hint: Carefully prepare a table of Chipteeh’s earnings and dividends for each of the next three years. Pay close attention to the change in the payout ratio in $t=2$ .)
c. No one else in the market perceives the threat to Chiptech’s market. In fact, you are confident that no one else will become aware of the change in Chiptech’s competitive status until the competitor firm publicly announces its discovery near the end of year $\text{2}$ . What will be the rate of return on Chiptech stock in the coming year (ie, between $t=0$ and $t=1$ )?

d. What will be the rate of return in the second year (between $t=1$ and $t=2$ )?
e. What will he the rate of return 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 dividends and market prices over time might help.)