Question

Holt enterprises recently paid a dividend, D0, of $2.75. It expects to have a non-constant growth of 20% for 3 years followed by a constant rate of 5% thereafter. The investor in this stock requires a return of 12%.

a) What is the firm’s intrinsic value, (P_0 ) ̂, today?

b) If the market price of the stock is $60 today, is the expected return to an investor who buys this stock at $60 greater than, equal to, or less than the 12% required return?

Answer 1

	Calculation of value during abnormal stage
a)	Year	Dividend working	Dividend ($)	Discounting factor @ 12%	PV of dividends ($)
	1	2.75*120%	3.30	0.893	2.946
	2	3.30*120%	3.96	0.797	3.157
	3	3.96*120%	4.752	0.712	3.382
				Total	9.486
	Value during constant stage
	As per Gorden model,
	P3= (D3*(1+g))/(Re-g)
		(4.752*(1+0.05))/(0.12-0.05)
		$71.28
	PV today= $71.28*0.712
		$50.751
	Value of share today= $(9.486+50.751)
		$60	(rounded off to nearest whole number)
b)	As the market price is equal to the intrinsic value of share (calculated above) i.e. $60, so the expected return is equal to the required return of 12% (indicating market is trading at equilibrium; arbitrage opportunity doesnot exists)