Question

Suppose a bank has an unexpectedly large number of withdrawals on a given day. Explain one way that they can meet their required reserves.

Suppose you are trying to decide whether or not to invest in a particular company. The company currently offers a $4 dividend. You expect that dividend to grow at 1.5% per year indefinitely. You require a 5% return. What is the maximum price you’re willing to pay for this stock?

Give a reason why your required return could fall to 4%. What is the new maximum price you’re willing to pay? Does this change make intuitive sense?

Answer 1

Assuming D0 is $ 4.

Stock Price : Price of any security is present value of future cash flows it, that are discounted at specified discount rate.

Stock Price = D1 / [  Ke - g ]

D1 = D0 ( 1 +g )

D1 - Div after 1 Year

P0 = Price Today

Ke - required Ret

g - Growth Rate.

Part A:

Particulars	Amount
D0	$   4.00
Growth rate	1.50%
Ke	5.00%

Price of Stock is nothing but PV of CFs from it.
Price = D1 / [ Ke - g ]
D1 = D0 ( 1 + g )
= $ 4 ( 1 + 0.015 )
= $ 4 ( 1.015 )
= $ 4.06

Price = D1 / [ Ke - g ]
= $ 4.06 / [ 5 % - 1.5 % ]
= $ 4.06 / [ 3.5 % ]
= $ 116

Where
D0 = Just Paid Div
D1 = Expected Div after 1 Year
P0 = Price Today
Ke = Required Ret
g = Growth Rate

Part B:

Particulars	Amount
D0	$   4.00
Growth rate	1.50%
Ke	4.00%

Price of Stock is nothing but PV of CFs from it.
Price = D1 / [ Ke - g ]
D1 = D0 ( 1 + g )
= $ 4 ( 1 + 0.015 )
= $ 4 ( 1.015 )
= $ 4.06

Price = D1 / [ Ke - g ]
= $ 4.06 / [ 4 % - 1.5 % ]
= $ 4.06 / [ 2.5 % ]
= $ 162.4

Where
D0 = Just Paid Div
D1 = Expected Div after 1 Year
P0 = Price Today
Ke = Required Ret
g = Growth Rate