Question

2) The current stock price (year 0) of the Sizzling Sausage Corporation is $27.50. According to your information and analysis, you expect this company to pay its first dividend of $2.50 in year 2, and from year 3 on, you expect to see a steady growth in dividends. Specifically, you figure out that the dividends in year 3 will be $2.75 and will then continue to grow for another 15 years at 3.5% per year, after which it will grow 2.5% per year forever. The appropriate discount rate is 9%.

If you currently own this stock, ignoring transaction costs what should you do according to the above information - buy more stock at the current market price or sell your stock? (Explain your answer using quantitative analysis)

Answer 1

Discount rate	9.0000%
Cash flows	Year	Discounted CF= cash flows/(1+rate)^year	Cumulative cash flow
-	0	-	-
-	1	-	-
2.500	2	2.10	2.104
2.750	3	2.12	4.23
2.846	4	2.02	6.24
2.946	5	1.91	8.16
3.049	6	1.82	9.98
3.156	7	1.73	11.70
3.266	8	1.64	13.34
3.380	9	1.56	14.90
3.499	10	1.48	16.38
3.621	11	1.40	17.78
3.748	12	1.33	19.11
3.879	13	1.27	20.38
4.015	14	1.20	21.58
4.155	15	1.14	22.72
4.301	16	1.08	23.80
4.451	17	1.03	24.83
4.607	18	0.98	25.81
72.652	18	15.40	41.21

terminal value = 4.607*1.025/(0.09 - 0.025) = 72.652

the intrinsic value of the stock = 41.21

so since the stock is undervalued today, one should buy more stock at current price