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

Solution

In the first case where the dividends have been considered forever

Value of stock=Dividend each year/rate of return

Putting values

100=Dividend each year/.1

Solving dividend each year=10

In the second case where the dividends have been considered for 90 years

Stock value=Dividend payment*((1-(1/(1+i)^m))/i)

where

i-rate of return-10%

m-number of periods -90

Dividend payment=10

Putting values in formula

Stock value=10*((1-(1/(1+.1)^90))/.1)

Stock value=99.98

Thus the Downward revision=100-99.98

Downward revision=$.02