Question

1). ABC Corporation’s stock price is trading at $75. If the company's last dividend payment was $5 what is the dividend grow rate average into the foreseeable future if required rate of return is 12% ?

2). Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the weather forecast included a 100% chance of rain by midday but Barbara did not watch the local news program. Is Barbara's prediction of good weather at lunch time rational? Why or why not?

3). If a corporation announces that it expects quarterly earnings to increase by 25% and it actually sees an increase of 22%, what should happen to the price of the corporation's stock if the efficient markets hypothesis holds, everything else held constant?

Answer 1

Solution for question 1

Gordon's single-stage growth model dictates that P = D₁/ (r - g)

where,

P is the current price of the stock

D₁ is the next-year's dividend =(D₀* (1+g))

r is the required rate of return or cost of equity

g is the expected growth in dividends in the foreseeable future

Plugging in the values we already know into this equation we get,

$75 = {$5 * (1 +g)}/ (0.12 -g)

$ 75 * (0.12 -g) = $5 * (1 +g)

$9 - ($75*g) = $5 + ($5 *g)

$9 - $5 = ($5 *g) + ($75*g)

$4 = ($5 + $75) *g

g = $4/ ($5+ $75) = $4/$80 = 0.05 or 5%

Hence, the company's dividend must grow at 5% per annum into perpetuity for the stock price to be $75 and discount rate at 12%

Solution for question 2

Had Barbara seen the weather forecast of a 100% chance of rain midday, and still decided to go out for picnic, that would have been totally irrational.

Barbara based her decision on going out for a picnic on the fact that there were blue skies. While that is not necessarily sound judgement, as weather can be fickle, it is not totally irrational either. Hence, Barbara's prediction of good weather at lunch time was to an extent rational.

Solution for question 3

In efficient markets hypothesis, all the information about a stock known by public is already factored into the stock price. Hence, if a company's earnings grew 22%, while the company had expected a growth of 25%, the price of the stock will fall on the news.