Question

Question 3: The current stock price (year 0) of the Sizzling Sausage Corporation (SSC) is $40.50. 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 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 and may ignore transaction costs, which of the following statements is true?

A) Sell your stock in SSC because the discount rate is much higher than the growth rate in dividends.

B) Purchase more stock in SSC because dividends are expected to continue to increase and grow indefinitely.

C) Sell your stock in SSC because based on your expectations the value of the stock is only $40.23

D) Purchase more stock in SSC because based on your expectations, the value of the stock is $98.46

Please let me see your solution. Thanks

Answer 1

The right option is C.

Year	Cash flow	Disc Factor @ 9%	Discounted CF
1	0	0.9174311927	0
2	2.5	0.8416799933	2.104199983
3	2.75	0.7721834801	2.12350457
4	2.84625	0.7084252111	2.016355257
5	2.94586875	0.6499313863	1.914612561
6	3.048974156	0.5962673269	1.81800367
7	3.155688252	0.5470342448	1.72626954
8	3.266137341	0.5018662797	1.639164196
9	3.380452147	0.4604277795	1.556454076
10	3.498767973	0.4224108069	1.477917402
11	3.621224852	0.3875328504	1.403343589
12	3.747967721	0.3555347251	1.332532674
13	3.879146592	0.3261786469	1.265294786
14	4.014916722	0.299246465	1.201449637
15	4.155438808	0.2745380413	1.140826031
15	66.15	0.2745380413	18.16069143
Total	40.8806194