Question

You are analyzing stock of Azure Corp. Firm paid a dividend of $3 per share and its dividends are expected to grow at 7% in future. Currently, similar risks stocks have required rate of return of 10%. Using this information:

    Calculate the Present value of the stock. (hint: dividend growth model)

    A year later, a broker offers to sell you the same stock for $73. Most recent dividend paid was $3.21 and growth rate is still 7%. If you determine that appropriate risk premium is 6.75%, and risk-free rate RF is 5.25%, what is the firm's current required return (calculating r).

    Using dividend growth model, determine the value of stock using new dividend and required return from part b.

    Given your answer in part c, would you buy the stock at $73 per share? Explain.

    Given your answer in part c, would you sell the stock at $73/share? Explain.

Answer 1

Present value of stock using Gordon's Dividend Growth Model

Formula = D1/(k-g)

Where D1 = Dividend

k = Required Rate of Return

g = Expected Dividend Growth Rate

Therefore the value of Stock would be

$3/(10%-7%)

=$3/3%

=$3/0.03

=$100

Calculation of Required Rate of Return during the next Year

Required Rate of Return = Risk free Rate of return + Risk Premium

Therefore Required Rate of Return, i.e., r = 5.25% + 6.75%

= 12%

Calcuation of value of stock during the next year with the following Data

Dividend per share = $3.21

Required Rate of Return = 12%

Dividend growth rate = 7%

Value of Stock = $3.21/(12%-7%)

=$3.21/5%

=$3.21/.05

=$64.20 per share

As calculated above the value of stock is $ 64.20 per share hence I wouldn't buy the share at $73 per share as the price is higher than it's worth

However, I would sell the stock at $73 per share as it's actual worth is $64.20.