Question

You are considering buying a share of stock in the tech company Neutrino, LLC for $250. You expect the stock to pay a dividend of $2 after 3 years and $10 after 4 years, but no dividends in years 1 and 2. You also expect to sell the stock after 4 years for $270.

a) If your bank account pays an interest rate of 3 percent, is Neutrino, LLC a good investment? What about if your bank pays an interest rate of 4 percent?

b) If your bank account pays an interest rate of 4 percent, what would the future sale price of stock in Neutrino, LLC have to be after 4 years for the current stock price of $250 to be fair value?

Answer 1

a)

Purchase price=$250

Expected sale price=$270

Dividend after year 3=$2

Dividend after year 4=$3

NPV of investment=-250+2/(1+i)^3+(3+270)/(1+i)^4

If i=3%

NPV of investment=-250+2/(1+3%)^3+(3+270)/(1+3%)^4=-$5.61

NPV is negative, its not a good investment.

If i=4%

NPV of investment=-250+2/(1+4%)^3+(3+270)/(1+4%)^4=-$14.86

NPV is negative, its not a good investment.

b)

Let the sale price be X

NPV of investment=-250+2/(1+4%)^3+(3+X)/(1+4%)^4

NPV should be zero if $250 is a fair price.

-250+2/(1+4%)^3+(3+X)/(1+4%)^4=0

-250+1.777993+(3+X)*0.854804=0

(3+X)*0.854804=248.222007

3+X=290.38

X=$287.38