Question

Assume​ you've generated the following information about the stock of​ Ben's Banana​ Splits: The​ company's latest dividends of ​$2.25 a share are expected to grow to ​$2.36 next year, to ​$2.48 the year after​ that, and to $2.60 in year 3. After​ that, you think dividends will grow at a constant 5​% rate.

a. Use the variable growth version of the dividend valuation model and a required return of 12​% to find the value of the stock.

b. Suppose you plan to hold the stock for three​ years, selling it immediately after receiving the $2.60 dividend. What is the​ stock's expected selling price at that​ time? As in part a​, assume a required return of 12​%.

c. Imagine that you buy the stock today paying a price equal to the value that you calculated in part a. You hold the stock for three​ years, receiving dividends as described above. Immediately after receiving the third​ dividend, you sell the stock at the price calculated in part b. Use the IRR approach to calculate the expected return on the stock over three years. Could you have guessed what the answer would be before doing the​ calculation?

d. Suppose the​ stock's current market price is actually ​$31.69. Based on your analysis from part a​, is the stock overvalued or​ undervalued?

e. A friend of yours agrees with your projections of​ Ben's Banana Splits future​ dividends, but he believes that in three​ years, just after the company pays the ​$2.60 dividend, the stock will be selling in the market for $56.79. Given that​ belief, along with the​ stock's current market price from part d​, calculate the return that your friend expects to earn on the stock over the next three years.

Answer 1

a. Dividend year 1= 2.36
Dividend Year 2=2.48
Dividend Year 3=2.60
Terminal Value =Dividend Year 3*(1+g)/(Required Rate-g) =2.60*(1+5%)/(12%-5%) =39
Value of the stock =Dividend/(1+r)+Dividend Year 2/(1+r)^2+Dividend Year 3/(1+r)^3+Terminal value/(1+r)^3
=2.36/(1+12%)+2.48/(1+12%)^2+2.60/(1+12%)^3+39/(1+12%)^3 =33.69

b. Expected Selling price =Dividend Year 3*(1+g)/(Required Rate-growth) =2.60*(1+5%)/(12%-5%) =39

c.
Value in year 3 =39+2.60 =31.60
IRR using financial Calculator
CF0=-33.69;CF1=2.36;CF2=2.48;CF3=31.60;CPT IRR =12%
Rate of return =12%
Yes the answer could be guessed as it is same as required rate.

d. If current market price is 31.69 the stock is under valued as market value of bond is lower than intrinsic value of bond.