Question

1) The minimum required rate of return you need to earn is 17%. You expect the...

1) The minimum required rate of return you need to earn is 17%. You expect the dividend in the next period is $4. The current market price of the stock is $35.2 the growth rate of dividends is 4.2% what is going to happen to the market price? (Increase? Decrease? Not change? Increase then decrease? Decrease then increase?)

2) a mutual fund manager recommend you to buy a stock at $23 which has the following information:
The current dividend(D0) = $3
Constant growth rate of dividend = 0%
The required rate of return on the stock = 14.2%
What is your investment decision? (Buy? Not Buy? Same? Not enough information?)

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Homework Answers

Answer #1

1. The value of the stock is computed as shown below:

= Next period dividend / (required rate of return - growth rate)

= $ 4 / (0.17 - 0.042)

= $ 31.25

Since the current market price of $ 35.2 is greater than the fair value of stock of $ 31.25, hence the stock is overvalued and we can expect to decrease.

2. The value of the stock is computed as shown below:

= D0 / required rate of return

= $ 3 / 0.142

= $ 21.13 Approximately

Since the price as recommended by the manager of $ 23 is greater than the fair value of $ 21.13, it implies that the stock is overvalued. Hence we shall not buy the stock.

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

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