Question

Assume​ you've generated the following information about the stock of​ Bufford's Burger​ Barns: The​ company's latest dividends of ​$4.15 a share are expected to grow to $4.61 next​ year, to $5.12 the year after​ that, and to $5.68 in year 3. After​ that, you think dividends will grow at a constant 4​% rate.

a. Use the variable growth version of the dividend valuation model and a required return of 15% to find the value of the stock.

b. Suppose you plan to hold the stock for three​ years, selling it immediately after receiving the ​$5.68 dividend. What is the​ stock's expected selling price at that​ time? As in part (a​), assume a required return of15%

c. Imagine that you buy the stock today paying a price equal to the value that you calculated in part ​(a​).You hold the stock for three​ years, receiving dividends as described above. Immediately after receiving the third​ dividend, you sell the stock at the price calculated in part ​(b​). Use the IRR approach to calculate the expected return on the stock over three years. Could you have guessed what the answer would be before doing the​ calculation?

d. Suppose the​ stock's current market price is actually $45.92. Based on your analysis from part​(a​), is the stock overvalued or​ undervalued?

e. A friend of yours agrees with your projections of​ Bufford's future​ dividends, but he believes that in three​ years, just after the company pays the ​$5.68 dividend, the stock will be selling in the market for ​$55.10. Given that​ belief, along with the​ stock's current market price from part ​(d​),calculate the return that your friend expects to earn on the stock over the next three years.

Answer 1

a.

	15.0000%
Cash flows	Year	Discounted CF
-	0	0.00
4.61	1	4.01
5.12	2	3.87
5.68	3	3.73
53.70	3	35.31

value = 46.92

b. expected selling price = 5.68*1.04/(0.15 - 0.04) = 53.70

c.

Cash flows	Year
(46.92)	0
4.61	1
5.12	2
59.38	3

IRR = 15.00%

d. undervalued

e.

Cash flows	Year
(46.92)	0
4.61	1
5.12	2
60.78	3

IRR = 15.82%