Question

Three people are looking to purchase stock PPP that is predicted to raise its dividend by 3% annually. The company pays a 82 cent dividend. Person A does not have much information, just what they heard on television, and feels the stock could go up but because of the risk involved needs a 13% return. Person B read an article on the stock and has done some research into what the company’s prospects for the future are so feels that there is lower risk and only needs a 9% return. Person C has talked to his broker, received a research report, and feels there is only a small risk and can live with a 7% return. The stock is currently selling for $15.74. Which of the three will buy the stock based on whether the stock is fairly valued? Show your work? According to the text and lectures, would the prices that these three people would pay for the stock change if the Federal Reserve cut interest rates? What would be the effect on the financial markets?

Answer 1

1) Stock Value = Dividends per Share / (Cost of Equity capital – Dividend Growth Rate)

Case 1) 13% required return
0.82 / ( 13 - 3 ) = 0.82 / 10% = 8.20

Case 2) 9% required return
0.82 / ( 9 - 3 ) = 0.82 / 6% = 13.67

Case 3) 7% required return
0.82 / ( 7 - 3 ) = 0.82 / 4% = 20.5

Stock is overvalued for those who are seeking 13% and 9% return respectively as corresponding price of stock for these required return is $8.20 and $13.67. So they won't buy it.
A person seeking only 7% return will buy that as price corresponds to $20.5 and the current stock price is undervalued for him.

2) If the Fed cuts the interest rate then the cost of capital will also decrease and required rate of return or risk premium to compensate the risk will also be lower. In such a scenario, price these investors are willing to invest will change.

3) Financial markets will take a cut in interest rate as a positive because lowering risk-free rate also lowers the risk premium.
Lower risk premium means more investors in the market as they tend to be the risk-averse.