Question

Section 1

a. The broker offers to sell you some shares of ABC & Co. common stock that paid annual dividend of $2.00 yesterday. ABC’s dividend is expected to grow at 5% per year for the next 3 years. If you buy the stock, you plan to hold it for 3 years and then sell it. The appropriate discount rate is 12%.

i. Calculate the expected dividend for each of the next 3 years. [3 marks]

ii. Given that the first dividend payment will occur 1 year from now, find the present value of the dividends stream. [3 marks]

iii. You expect the stock price at the third year to be $34.74. Discounted at a 12% rate, what is the present value of this expected future stock price? [3 marks]

iv. If you plan to buy the stock, hold it for 3 years, and sell it for $34.73, what is the most you should pay for it today? [3 marks] v. Calculate the present value of this stock by using the constant growth model. Assume that g = 5% and that it is constant. [3 marks]

b. From the perspective of either an investor and firm, which of the financing ways is preferable? Debt or equity? Please justify your choice with relevant reasons (Not more than 200 words). [10 marks]

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Answer 1

i) D0= Current dividend=$2.00

g= annual growth rate =5%=0.05

D1=Expected dividend in year 1=D0*(1+g)=2*1.05=$2.10

D2=Expected dividend in year 2=D1*(1+g)=2.1*1.05=$2.21

D3=Expected dividend in year 3=D2*(1+g)=2.21*1.05=$2.32

.ii) Discount rate =12%=0.12

Present Value of D1=2.10/1.12=$1.88

Present Value of D2=2.21/(1.12^2)=$1.76

Present Value of D3=2.32/(1.12^3)=$1.65

Present Value of dividend stream=1.88+1.76+1.65=$5.28

.iii) Price of stock at end of year3 =$34.74

Present Value of Price =34.74/(1.12^3)=$24.73

Present Value of expected future price=$24.73

iv) Maximum you should pay today=Present Value of future cash flows=$24.73+Present Value of dividend stream=$24.73+$5.28=$30.01

CONSTANT GROWTH MODEL:

D4= Dividend in Year 4=D3*(1+g)=2.32*1.05=$2.43

R=Required Return =12%=0.12

g=constant growth rate=5%=0.05

Fair Price at end of year 3=Horizon Value=D4/(R-g)=2.43/(0.12-0.05)=$34.73

Present Value of the stock=P0=34.73/(1.12^3)+5.28=24.72+5.28=$30.00

b. From the perspective of either an investor and firm, EQUITY is preferable because debt increases the risk