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Chapter 4: Q.4CP (page 402)

Janet Ludlow is preparing a report on U.S.-based manufacturers in the electric toothbrush industry and has gathered the information shown in Tables 12.8 and 12.9. Ludlow’s report concludes that the electric toothbrush industry is in the maturity (i.e., late) phase of its industry life cycle.

a. Select and justify three factors from Table 12.8 that support Ludlow’s conclusion.

b. Select and justify three factors from Table 12.9 that refute Ludlow’s conclusion.

Short Answer

Expert verified

Answer

a. Levelling of ROE, declining average P/E ratio, and increasing dividend payout

b. Growth forecasts of a mature industry, untapped market and new entry..

Step by step solution

01

Step by Step Solution Step 1: Justification of Ludlow’s conclusion ‘a’

From the table above

(i) The industry wide ROE is leveling off, implying that industry may be approaching a later stage of life cycle.

(ii) Declining average P/E ratios imply that investors are becoming less optimistic about growth.

(iii) Increasing dividend payout indicates firm’s not seeing reason to reinvest in it.

02

Refusal of Ludlow’s conclusion ‘b’

From the table above:

(i) Industry forecasted growth rate at 10-15% implies a mature industry.

(ii) Untapped new US markets which are seeing entry by some firms.

(iii) Entry of new manufacturers in the market.

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Most popular questions from this chapter

The market consensus is that Analog Electronic Corporation has an ROE = 9% and a beta of 1.25. It plans to maintain indefinitely its traditional plowback ratio of 2/3. This year’s earnings were $3 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 14%, and T-bills currently offer a 6% return.

a. Find the price at which Analog stock should sell.

b. Calculate the P/E ratio.

c. Calculate the present value of growth opportunities.

d. Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. The market is still unaware of this decision. Explain why V0 no longer equals P0 and why V0 is greater or less than P0 .

The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its earnings in dividends, and the latest earnings announced were \(10 per share.

Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per year on all reinvested earnings forever.

a. What is the intrinsic value of a share of Xyrong stock?

b. If the market price of a share is currently \)100, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected one-year holding-period return on Xyrong stock?

General Weed killers dominate the chemical weed control market with its patented product Weed-ex. The patent is about to expire, however. What are your forecasts for changes in the industry? Specifically, what will happen to industry prices, sales, the profit prospects of General Weedkillers, and the profit prospects of its competitors?

What stage of the industry life cycle do you think is relevant for the analysis of this market?

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 \(1 per share last year and just paid out a dividend of \).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 Chiptech stock? The required return for the computer chip industry is 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 15%, and, because of falling demand for its product, Chiptech 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 Chiptech’s intrinsic value per share?

( Hint: Carefully prepare a table of Chiptech’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 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? In the second year (between t = 1 and t = 2)? 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.)

Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2% of sales to 1% of sales. Ignoring taxes, what are the immediate effects on (a) , operating income and (b) operating cash flow?
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