Question

You are told by your investment advisor that Laduma Co. is expected to earn R5 per share next year, R6 per share the following year and that thereafter earnings are expected to grow by 8 percent per year. The dividend payout ratio is 60 percent and the required rate of return on Laduma shares is 15 percent. If the current share price is R40, would you expect your adviser to make a buy, hold or sell recommendation? If transaction costs are R2,50 per share, would you follow his advice?

Answer 1

Solution :-

Dividend in Year 1 = EPS 1 * Dividend Payout Ratio = $5 * 60% = $3

Dividend in Year 2 = EPS 2 * Dividend Payout Ratio = $6 * 60% = $3.60

Now Price in Year 2 ( P2 ) = D2 * ( 1 + g ) / ( Ke - g ) = $3.60 * ( 1 + 0.08 ) / ( 0.15 - 0.08 )

= $55.543

Now Value of Share = [ $3 / ( 1 + 0.15 ) ] + [ $3.60 / ( 1 + 0.15 )² ] + [ $55.543 / ( 1 + 0.15 )² ]

= $2.6087 + $2.722 + $41.998

= $47.33

Now Current Price with transaction Cost = $40 + 2.50 = $42.50

Now as Current price is lower than Fair Price of Stock So We have advice to buy the stock

If there is any doubt please ask in comments

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