In: Finance
Assume you've generated the following information about the
stock of Bufford's Burger Barns: The company's latest dividends
of $3.51 a share are expected to grow to $3.90 next year, to
$4.33 the year after that, and to $4.81 in year 3. After that,
you think dividends will grow at a constant 6 % rate.
a. Use the variable growth version of the dividend valuation model
and a required return of 15 % to find the value of the
stock.
b. Suppose you plan to hold the stock for three years, selling it
immediately after receiving the $4.81 dividend. What is the
stock's expected selling price at that time? As in part a, assume
a required return of 15 %.
c. Imagine that you buy the stock today paying a price equal to the
value that you calculated in part a. You hold the stock for three
years, receiving dividends as described above. Immediately after
receiving the third dividend, you sell the stock at the price
calculated in part b. Use the IRR approach to calculate the
expected return on the stock over three years. Could you have
guessed what the answer would be before doing the
calculation?
d. Suppose the stock's current market price is actually $45.83 .
Based on your analysis from part a, is the stock overvalued or
undervalued?
e. A friend of yours agrees with your projections of Bufford's
future dividends, but he believes that in three years, just after
the company pays the $4.81 dividend, the stock will be selling in
the market for $56.79 . Given that belief, along with the
stock's current market price from part d, calculate the return
that your friend expects to earn on the stock over the next three
years.
a)
Value of the stock = PV of Dividend in year 1 + PV of dividend in year 2 + PV of dividend in year 3 + PV(TV of dividends)
PV of dividend in year 1 = (3.9) / (1.15) = $ 3.39
PV of dividend in year 2 = (4.33)/(1.15)^2 = $ 3.27
PV of dividend in year 3 = (4.81)/(1.15)^3 = $ 3.16
TV of dividends = 4.81*[(1+6%)/(0.15-0.06)] = 56.65
PV(TV of dividends) = 56.65/(1.15)^3 = $37.24
Value of Stock = 37.24 + 3.16 + 3.27 + 3.39 = $ 47.06
b)
Value of stock today = PV of dividend in year 1 + PV of dividend in year 2 + PV of dividend in year 3 + PV (selling price)
This is nothing but the TV of dividends = $ 56.65
c)
Price of stock = -47.06
CF1 = $ 3.9
CF2 = $ 4.33
CF3 = $ 4.81 + 56.65 = $ 61.46
So IRR of stock = ?
47.06 = 3.9/(1+IRR) + 4.33/(1+IRR)^2 + 61.46/(1+IRR)^3
IRR = 15%
Yes, we could have guessed the IRR as the value of stock is calculated using the required return of 15%. Hence IRR = Required rate of return in this case
d)
Based on the analysis as Market price is less than the value of stock today ie 47.06, the stock is undervalued.
CF3 = $