Question

Suppose you calculate the value of a stock to be $100 per share. No dividend growth is expected and the firm’s shareholders require a 10% return on their investment. Your boss challenges your assumption that dividends will pay forever. “I expect the corporation will die in 90 years” he says. By how much should you revise your share price valuation downward based on your boss’s assumption?

Select one:

a. $0.02

b. $10

c. $100

d. Not enough information to solve this problem

Answer 1

- You thought that the Dividend will be paid annually forever without the dividend growth rate.

Calculating the amount of annual dividend paid by companY:-

Annual Dividend = Current extimated price*Required Return

Annual Dividend = $100*10%

Annual Dividend = $10

- Now your boss challenges your assumption that dividends will paid forever, he says that the corporation will die in 90 years.

Calculating the Price of Stock with fixed annual dividend for 90 years using PV of annuity formula:-

Where, C= Annual Dividend = $10

r = Required Return = 10

n= no of periods = 90

Price = $99.98

So, the amount by which your share price valuation goes downward based on your boss’s assumption = $100 - $99.98

= 0.02

Option A

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