Question

An investor with a required return of 14 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase.

The information is as follows: Firm A B C Current earnings $ 1.60 $ 3.50 $ 6.70 Current dividend $ 1.40 $ 4.40 $ 5.90 Expected annual growth rate in 6 % 3 % -3 % dividends and earnings Current market price $ 24 $ 46 $ 37

What is the maximum price that the investor should pay for each stock based on the dividend-growth model?

Round your answers to the nearest cent.

Stock A: $

Stock B: $

Stock C: $

If the investor does buy stock A, what is the implied percentage return?

Round your answer to two decimal places. %

If the appropriate P/E ratio is 17, what is the maximum price the investor should pay for each stock?

Round your answers to the nearest cent.

Stock A: $

Stock B: $

Stock C: $

If the appropriate P/E ratio is 3, what is the maximum price the investor should pay for each stock?

Round your answers to the nearest cent.

Stock A: $

Stock B: $

Stock C: $

Answer 1

Answer : Calculation of maximum Price under Dividend Discount Model :

Maximum Price = Expected Dividend / (Required Return - Growth rate)

Maximum Price of A= [1.40 * (1 + 0.06)] / (0.14 - 0.06) = 18.55

Maximum Price of B= [4.40 * (1 + 0.03)] / (0.14 - 0.03) = 41.2

Maximum Price of C= [5.90 * (1 - 0.03)] / (0.14 + 0.03) = 33.66

(b.) If the investor does buy stock A, what is the implied percentage return

Implied % Return = [Expected Dividend / Current Price] + Growth rate

= {[1.40 * (1 + 0.06)] / 24 } + 0.06

= 12.18%

(c.) Calculation of Price through PE ratio

Price = PE ratio * Earnings

Price of A = 17 * 1.60 = 27.2

Price of B = 17 * 3.50 = 59.5

Price of A = 17 * 6.70 = 113.9

(d.) Calculation of Price through PE ratio when PE ratio is 3

Price of A = 3 * 1.60 = 4.8

Price of B = 3 * 3.50 = 10.5

Price of A = 3 * 6.70 = 20.1