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

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The expected share price of Jumbo Transport can be calculated using the Gordon Growth Model (Dividend Discount Model for a firm with constant growth), which is P = D1 / (k - g), where P is the price, D1 is the dividend in the next period, k is the cost of equity, and g is the growth rate of dividends.First, calculate the retained earnings which will be reinvested: $2.50 * 20% = $0.50.The growth in earnings due to the reinvestment: $0.50 * 25% = $0.125.The growth rate (g) as a percentage of total earnings: $0.125 / $2.50 = 5%.The dividend paid out (D1) is the earnings not reinvested: $2.50 * (1 - 20%) = $2.00.Using the Gordon Growth Model: P = $2.00 / (12% - 5%) = $2.00 / 0.07 = $28.57.

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