Question

For all the following, consider the company, XYZ Inc.

a.         It’s preferred stock pays a dividend of $1.00. If you require a return of 10 percent, what is the most you would pay for their preferred stock today?

b.         Preferred stock is ok, but you really want common stock because of the growth potential. Consider that XYZ just paid a regular dividend of $4. If the required return on equity is 20 percent, what is the most you’d pay for their common stock if you expect the dividend to grow at 10 percent per year?  

c.         After the market closed today, XYZ announced that it will reduce its dividend next year by 75% and by 50% the following year (based on the $4 just paid). Growth is expected to bounce back 50% in the third year, then resume its 10% annual growth rate indefinitely. What is the most you would pay for XYZ common stock when the market opens tomorrow morning?

d.         Closely examine the model you are using to calculate the stock value. List five (5) major factors that the company can control that directly influence the value of its stock in this model. That is, as CEO what can you control?

Answer 1

a)

Price of preferred share can be calculated by the following formula,

Price = Dividend / Rate pf return = 1 / .10 = $10

Hence the price of the preferred share today is $10.

b)

D0 = $4

r = 20%

g = 10%

We can calculate the price of the share by using Gordon's growth model formula,

Price = D0(1+g)/(r-g)

= 4(1+.1) / (.20 - .10)

= 4.4 / .10

= $44

Hence the price of the share is $44

c)

D0 = $4

D1 = 4 * (1 +g) = 4 ( 1 - .75) = 4 * .25 = $1

D2 = 1 * (1 + g) = 1 ( 1 - .50) = 1 * .50 = $.5

D3 = .5 * (1 + g) = .5 (1 + .50) = $.75

Using Gorden's growth model

Price of share = D3(1+g)/(r-g)*(1+r)^3

= .75(1+.10) / ((.20-.10)*(1+.10)^3)

= .825 / (.10 * 1.1^3)

= $6.198 or $6.2(approx)

Hence the current price is $6.2

d)

We used the Dividend Discount model also known as Gordon's growth model. It is a model used for predicting the price of a share based on a theory that its price is equal to the sum of all future dividends discounted back to their present values. It considers factors such as dividend payout ratio and market expected returns.

Formula of DDM

Price of share = Expected dividend(D1) / (required return - dividend growth rate)

Major factors that the company can control to influence the value of a stock are

1) The expected dividend is a crucial factor in determining the price of the share. More dividends lead to a higher share price.

2) Required return or cost of capital is the compensation the investors demand in exchange for bearing the risk of owning the share of the company. The higher the required return, the less will be the price of the share.

3) The growth rate is the rate at which the dividends will grow in the next few years. The more the growth rate, the higher will be the price.

4) The dividend payout ratio is the amount of dividend paid by the company out of its profits. If a company pays more dividends, it saves less money for the growth of the organization. Hence more dividend lead to a lower growth rate.

5) The company estimates the expected future growth rate which determines future dividends. The problem is it is difficult to predict future expected dividends. It is rare for companies to show constant dividend growth due to financial difficulties or successes.

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