Question

a) Suppose you are looking at a stock that is currently selling for $100, that you expect to pay dividend of $15 per year, and that you expect to be worth $125 four years from now, when you expect to sell it. If you employ a 15% discount rate when making this calculation how much will you be willing to pay for this stock?

b) How much will you be willing to pay for this stock if you use a discount rate of 20% rather than 15% when making this calculation?

Answer 1

a)

Dividend per year=D=$15

Number of periods=n=4

Selling price after 4 years=S=$125

Rate of interest=i=15%

Fair price of stock=PV of cash inflows

Fair price of stock=D*(P/A,0.15,4)+S*(P/F,0.15,4)

(P/F,0.15,4)=1/(1+0.15)^4=0.5718

Fair price of stock=15*2.8550+125*0.5718=$114.30

I would be willing a pay a sum of $114.30 for this stock.

Current market price is $100, I would be happy to buy at $100

b)

Fair price of stock=D*(P/A,0.20,4)+S*(P/F,0.20,4)

(P/F,0.20,4)=1/(1+0.15)^4=0.4823

Fair price of stock=15*2.5887+125*0.4823=$99.12

I would be willing a pay a sum of $99.12 for this stock.

Current market price is $100, I would not be buy this stock at $100