Question

Assume? you've generated the following information about the stock of? Bufford's Burger? Barns: The? company's latest dividends of ?$3.78 a share are expected to grow to $3.97 next? year, to $4.17 the year after? that, and to $4.38 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 15?% to find the value of the stock.

b. Suppose you plan to hold the stock for three? years, selling it immediately after receiving the $4.38 dividend. What is the? stock's expected selling price at that? time? As in part ?(a?), assume a required return of 15?%.

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 $38.47. Based on your analysis from part (a?), is the stock overvalued or? undervalued?

e. A friend of yours agrees with your projections of? Bufford's future? dividends, but he believes that in three? years, just after the company pays the $4.38 dividend, the stock will be selling in the market for $55.10. 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

I am going to answer the first 4 parts of the question:

a) Terminal Value of the stock at the end of Year 3 will be:

4.38*(1.05)/(0.15-0.05)=45.99

The following table states the dividend and its discounted value at the rate of 15%.

Year	1	2	3	3
Dividend	3.970	4.170	4.380	45.990
Discounted Value	3.452	3.153	2.880	30.239

Therefore, the price of stock (sum of discounted value)=

3.452+3.153+2.880+30.239= 39.724

b) In that case we are only expected to receive the terminal value of 45.99.

Therefore, the price of the stock will be 45.99

c) Find the below cash flows:

Year	0	1	2	3
Cash Flows	-39.724	3.970	4.170	50.370

Using the excel IRR function we get an IRR of 15 % which is the same as the discounted rate used.

d) Since the market price of the stock of $ 38.47 is less than $ 39.724 the stock is undervalued.