Question

Problem 11-03

An investor with a required return of 16 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase. The information is as follows:

Firm		A		B		C
Current earnings	$	2.10	$	3.10	$	6.50
Current dividend	$	1.30	$	3.70	$	7.70
Expected annual growth rate in		5	%	1	%	-2	%
dividends and earnings
Current market price	$	16	$	30	$	43

Stock A: $  

Stock B: $  

Stock C: $  

  %

Stock A: $  

Stock B: $  

Stock C: $  

1. What is the maximum price that the investor should pay for each stock based on the dividend-growth model? Round your answers to the nearest cent.
2. If the investor does buy stock A, what is the implied percentage return? Round your answer to two decimal places.
3. If the appropriate P/E ratio is 12, what is the maximum price the investor should pay for each stock? Round your answers to the nearest cent.
4. If the appropriate P/E ratio is 5, what is the maximum price the investor should pay for each stock? Round your answers to the nearest cent.

   Stock A: $  

   Stock B: $  

   Stock C: $  

Answer 1

I have answered the question below

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Answer:

maximum price that can be paid in the given conditions are:
for firm a = dividend/ return from div. = 1.3/(0.16-0.05) = 11.818 ($)
for firm b = 3.7/(0.16-0.01) = 24.67 ($)
for firm c = 7.7/(0.16-(-0.02)) = 42.778 ($)
b)
return of stock A = dividend/price + growth
=> = 1.3/16 + 0.05 = 13.125%
c)
maximum price based on P/E =12, i.e. P = 12E,
for firm a = 12*2.1 =25.2 ($)
for firm b = 12*3.1 = 37.2 ($)
for firm c = 12*6.5 = 72.8 ($)
All prices on P/E = 12 basis exceeds based on return in part(a) above. So no stock is buyable.
d)

If P/E = 5 , max price of a, b, c = 10.5, 15.5, 32.5