Question

The last dividends paid out to firm ABC’s stockholders were $5 per share. The current market value of the stock is $100. The dividends are expected to grow at a rate of 10% for the next 2 years followed by a constant growth rate of 6%. The required rate of return on the firm’s stock is 12%. A) Would you purchase the stock? B) Calculate the expected rate of return assuming a constant rate of dividends growth of 8%.

Answer 1

	Step1: Computation of Vaue for the 1st 2 years
Ans a			Amount in $
		Particulars	Year1	Year2	Total
	a	Expected Dividend	5.5	6.05
			(5*1.1)	(5.5*1.1)
	b	Discounting factor for 12%	0.89	0.80
	c	Presnt value of dividends	4.91	4.82	9.73
	Step2: Computation of Horizon value
	Dividend for 3rd year=	6.05*1.06=	$6.41
	Horizon Value of stock at the end of 2nd year=	Dividend for 3rd year
	(As per gordon model)		Ke-g
			=	6.41/(0.12-0.06)
			=	106.83
	Present value of stock= 106.83/(1.06)^2
	=	$                                   95.08
	Fair value of stock = step1 + step2
	=	9.73+95.08
	=	104.81
	The current price of stock is $100 but its actual value is $104.81. So the stock is undervalued and we should purchase it.
Ans b	Expected return (ER) is calculated as=	(Expected dividend/Current price)+growth
		=	(5.5/100)+0.08
			13.50%