Jumbo Transport, an air-cargo company, expects to have earnings per share of $2.50 in the coming year. It decides to retain 20% of these earnings in order to lease new aircraft. The return on this investment will be 25%. If its equity cost of capital is 12%, what is the expected share price of Jumbo Transport?

Question

Quizplus · Accepted Answer

First, calculate the amount of earnings that will be retained:

Retained earnings = Earnings per share * Retention rate 
Retained earnings = $2.50 * 20% = $0.50

Next, calculate the return on the investment:

Investment return = Retained earnings * Return on investment 
Investment return = $0.50 * 25% = $0.125

Subtract the investment return from the earnings per share to get the earnings per share available to shareholders:

Earnings available to shareholders = Earnings per share - Investment return 
Earnings available to shareholders = $2.50 - $0.125 = $2.375

Now, calculate the dividend per share:

Dividend per share = Earnings available to shareholders * (1 - Retention rate) 
Dividend per share = $2.375 * (1 - 20%) = $1.90

Finally, use the dividend discount model to calculate the expected share price:

Expected share price = Dividend per share / (Cost of equity - Growth rate) 
Expected share price = $1.90 / (12% - 5%) = $28.57

Therefore, the expected share price of Jumbo Transport is $28.57. Choice B is the correct answer.

Jumbo Transport, an Air-Cargo Company, Expects to Have Earnings Per