Question

1. A company just paid a dividend of $2.16. The dividend is expected to grow at a rate of 3.5%. If it is required rate of return on the stock is 8.0% and the stock is currently priced at $49.20, should they buy or sell?

   • You should buy it: it is overvalued by $0.48.
   • You should buy it: it is undervalued by $0.48.
   • You should sell it: it is undervalued by $1.20.
   • You should sell it: it is overvalued by $1.20.
   • You should sell it: it is overvalued by $0.48.

2. 12 years ago, your aunt and uncle decided to invest their entire tax refund from Uncle Till of $2,896 in an account that earns a 6.5 percent annual interest. Assuming annual compounding, how much do they have in the account today?

   • $5,827.32
   • $6,023.44
   • $6,165.86
   • $6,218.03
   • None of the above

Answer 1

The value of the stock is computed as shown below:

= Dividend just paid x (1 + growth rate) / (required return - growth rate)

= ($ 2.16 x 1.035) / (0.08 - 0.035)

= $ 2.2356 / 0.045

= $ 49.68

Since the current price of the stock is less than the fair value of the stock. Hence the stock is undervalued by $ 0.48 as shown below:

= $ 49.68 - $ 49.20

= $ 0.48

So, the correct answer is option of You should buy it: it is undervalued by $0.48.

The amount is computed as shown below:

Future value = Present value x (1 + r)ⁿ

= $ 2,896 x 1.065¹²

= $ 6,165.86 Approximately

Feel free to ask in case of any query relating to this question