Question

1. An investor plans to hold Newco’s stock for 2 years. Newco expects to pay its common equity shareholders, $0.25 per share over the next 2 years. The investor anticipates Newco’s stock will close the end of that time period at $40 per share. Given a rate of return of 10%, what is the value of Newco’s common stock at the end of the 2-year time period?

Answer 1

Solution:

The formula for calculating the value of common stock is

Value of common stock = Present value of dividends for years ‘1 to n ‘ + Present value of common stock at year ‘ n ‘

As per the information given in the question we have n = 2 years

Thus the value of common stock = [ D₁ * ( 1 / ( 1 + r)¹ ) ] + [ D₂ * ( 1 / ( 1 + r)² ) ] + [ P₂ * ( 1 / ( 1 + r)² ) ]

As per the information given in the question we have

D₁ = $ 0.25 ; D₂ = $ 0.25 ; P₂ = $ 40.00 ; r = 10.00 % = 0.10   ;

Applying the available information in the formula we have the value of common stock as :

= [ $ 0.25 * ( 1 / 1.10 )¹ ] + [ $ 0.25 * ( 1 / 1.10 )² ] + [ $ 40.00 * ( 1 / 1.10 )² ]

= [ $ 0.25 * 0.909091 ] + [ $ 0.25 * 0.826446 ] + [ $ 40.00 * 0.826446 ]

= $ 0.227273 + $ 0.206612 + $ 33.057851

= $ 33.491736

= $ 33.49 ( when rounded off to two decimal places )

Thus the value of Newco’s Common Stock at the end of the 2-year time period = $ 33.49