Question

4. Harmon outstanding common stock is currently selling in the market for $24. Dividends of $1.60 per share were paid last year, and the company expects annual growth of 4%.

(a) What is the value of the stock to you, given a 9% required rate of return?

(b) Determine the expected rate of return for the stock.

(c) Should you purchase this stock? Why?

Answer 1

Answer a.

Last Dividend, D0 = $1.60
Growth Rate, g = 4%
Required Return, rs = 9%

Expected Dividend, D1 = D0 * (1 + g)
Expected Dividend, D1 = $1.60 * 1.04
Expected Dividend, D1 = $1.664

Value of Stock, P0 = D1 / (rs - g)
Value of Stock, P0 = $1.664 / (0.09 - 0.04)
Value of Stock, P0 = $1.664 / 0.05
Value of Stock, P0 = $33.28

Answer b.

Expected Dividend, D1 = $1.664
Growth Rate, g = 4%
Current Price, P0 = $24.00

Expected Return, r = D1 / P0 + g
Expected Return, r = $1.664 / $24.00 + 0.04
Expected Return, r = 0.0693 + 0.04
Expected Return, r = 0.1093 or 10.93%

Answer c.

You should purchase this stock as expected price is higher than the current market price.