Chip tech, 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 $.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 Chip tech stock? The required return for the computer chip industry is 15%, and the company has just gone ex dividend.
b. Suppose you discover that Chip tech’s competitor has developed a new chip that will eliminate Chip tech’s current technological advantage in this market. This new product, which will be ready to come to the market in 2 years, will force Chip tech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for its product, Chip tech will decrease the plowback ratio to .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 Chip tech’s intrinsic value per share?
c. No one else in the market perceives the threat to Chip tech’s market. In fact, you are confident that no one else will become aware of the change in Chip tech’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chip tech stock in the coming year? In the second year ? The third year ?