Question

Stock A and Stock B prices and dividends, along with the Market Index, are shown below. Stock prices are reported for December 31 of each year, and dividends reflect those paid during the year. The market data are adjusted to include dividends.

	Stock A:		Stock B:		Market Index
	Stock Price	Dividend	Stock Price	Dividend
2016	$25.88	$1.73	$73.13	$4.50	$17.09
2015	$22.93	$1.59	$78.45	$4.35	$13.27
2014	$24.75	$1.50	$73.13	$4.13	$13.01
2013	$16.13	$1.43	$85.88	$3.75	$9.96
2012	$17.16	$1.35	$90.00	$3.38	$8.40
2011	$11.44	$1.28	$86.33	$3.00	$7.05

1. Use the data given to calculate annual returns for Stock A, Stock B, and the Market Index, and then calculate average annual returns for the two stocks and the index. (Hint: Remember, returns are calculated by subtracting the beginning price from the ending price to get the capital gain or loss, adding the dividend to the capital gain or loss, and then dividing the result by the beginning price. Assume that dividends are already included in the index. Also, you cannot calculate the rate of return for 2011 because you do not have 2010 data.)
2. What dividends do you expect for Stock A over the next three years if you expect the dividend to grow at the rate of 3% per year for the next three years? In other words, calculate D1, D2, and D3. Note that D0 = $1.50.
3. Assume that Stock A has a required return of 13%. You will use this required return rate to discount the dividends calculated earlier. If you plan to buy the stock, hold it for three years, and then sell it for $27.05, what is the most you should pay for it?

Answer 1

Most you should pay for stock = present value next 3 years dividends + present value of price at end of 3 years

Present value = future value / (1 + required return)^{number of years}

Most you should pay for stock = $22.50