Question

Belarus Bearing Just paid a dividend of £7.20 per share on its stock. The dividends are expected to grow at a constant rate of 6% per year, indefinitely. If investors require (the discount rate) a 12% return on Belarus Bearing stock, what is the current price (Po)? What will the price be in 3 (P3) years? In 15 years (P15)?

n  If the stock is marketable at $95, what would be your investment decisions? Why?

n  If the firm’s risk as perceived by market participants suddenly increases, causing the required return to rise to 20 percent, what will be the common stock value today?

Answer 1

All values are in Lira

Given

1. Dividend paid (D0)= 7.20

2. Growth of dividend(g) : 6 %

3. Discount rate (required) (Ke) : 12 %

Solution:

In the normal scenario,

Current price of the stock(P0) : D0 X (1+g)/(Ke-g) Substituting the above given values : P0 = 7.20 X (1+0.06)/(0.12-0.06) = 127.2   

Since the value obtained from the formula is higher, the stock qualifies for a buy

Case 1: 3 years

Below table depicts the calculation for 3 years

		Year
		0	1	2	3
Dividend		7.2	7.632	8.09	8.58
Growth Rate in Dividend			6%	6%	6%
Terminal Value					134.83
Expected Return	12%
Present Value of dividend cash flows			6.81	6.45	6.10
Present Value of Terminal Value					95.97
Sum	115.34

The terminal value is calculated as ; 8.58/(12%-6%) = 134.83

The PV of the cash flows and terminal value are calculated by discounting the dividend and terminal value on the expected return.

The sum of the the present values comes to 115.34 which is more than 95.20, hence it can be bought.

When the expected rate of return increases to 20 %

		Year
		0	1	2	3
Dividend		7.2	7.63	8.09	8.58
Growth Rate in Dividend			6%	6%	6%
Terminal Value					57.79
Expected Return	20%
PV of cash flows			6.36	5.62	4.96
PV of Terminal Value					33.44
Sum	52.81

The Price of the stock drops to 50.38 , in this case it is not worth a buy

Case-2 : 15 years

		Year
		0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Dividend		7.2	7.632	8.08992	8.575315	9.089834	9.635224	10.21334	10.82614	11.47571	12.16425	12.8941	13.66775	14.48781	15.35708	16.27851	17.25522
Growth Rate in Dividend			6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%
Terminal Value																	287.587
Expected Return	12%
PV of cash flows			6.81	6.45	6.10	5.78	5.47	5.17	4.90	4.63	4.39	4.15	3.93	3.72	3.52	3.33	3.15
PV of Terminal Value																	52.54107
Sum	124.05

Stock is worth a buy in this case

		Year
		0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Dividend		7.2	7.632	8.08992	8.575315	9.089834	9.635224	10.21334	10.82614	11.47571	12.16425	12.8941	13.66775	14.48781	15.35708	16.27851	17.25522
Growth Rate in Dividend			6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%	6%
Terminal Value																	123.2516
Expected Return	20%
PV of cash flows			6.81	6.45	6.10	5.78	5.47	5.17	4.90	4.63	4.39	4.15	3.93	3.72	3.52	3.33	3.15
PV of Terminal Value																	7.999701
Sum	79.51

The second scenario states otherwise