Question

1)Bill, Jim, and Shelly are all looking to buy the same stock that pays dividends. Bill plans on holding the stock for one year. Jim plans on holding the stock for three years. Shelly plans on holding the stock until she retires in 10 years. Which one of the following statements is correct?

1. Bill will be willing to pay the most for the stock because he will get his money back in one year when he sells.

2. Jim should be willing to pay three times as much for the stock as Bill because his expected holding period is three times as long as Bill's.

3. Shelly should be willing to pay the most for the stock because she will hold it the longest and hence she will get the most dividends.

4. All three should be willing to pay the same amount for the stock regardless of their holding period.

2) Explain your answer using concepts and financial theory we studied during the class.

3) Reflection – the students also should include a paragraph in the initial response in their own words reflecting on specifically what they learned from the assignment and how they think they could apply what they learned in the workplace.

Answer 1

(1): The statement that is correct is the 4^th statement i.e. All three should be willing to pay the same amount for the stock regardless of their holding period.

(2): The concept of present value will be applicable here. Price of a stock or the amount that an investor is willing to pay for a stock is the present value of all future cash flows from the stock. The cash flows associated with a stock are the dividends that an investor receives on a periodic basis and the value or price at which stock is sold. For Bill the sale value will be received after one year only but there will be no dividends after that. For Jim sale value will be received after three years and Shelly will receive dividends for 10 years and then will receive the sale value. The present value concept of money will be factored in and so all three of them will be willing to pay the same amount for the stock regardless of their holding period.

(3): I have learned a lot from the assignment and particularly with regards to concepts like time value of money and valuation of stocks using the concept of time value of money by applying models like the dividend discount model. This can be applied in the workplace when I start my career as an equity analyst. The learnings will enable me to determine the intrinsic value of different stocks in a proper manner.