Question

(i) Your broker recommends that you purchase XYZ Inc. at $60. The stock pays a $2.40 dividend which is expected to grow annually at 8 percent. If you want to earn 12 percent on your funds, is this a good buy?

(ii) Presently, Stock A pays a dividend of $2.00 a share, and you expect the dividend to grow rapidly for the next four years at 20 percent. Thus the dividend payments will be

       Year Dividend

         1 $1.20

         2 1.44

         3 1.73

         4 2.07

After this initial period of super growth, the rate of increase in the dividend should decline to 8 percent. If you want to earn 12 percent on investments in common stock, what is the maximum you should pay for this stock?

*** This question is straight from my finance teacher. I don't understand your comment.

Answer 1

fair value of stock can be calculated by dividend discount model formula is

= D/(k-g)

where d1 is year 1 dividend = 2.4+8% = 2.592

k is cost of equity = 12%

growth = 8%

value = 2.592/(0.12-0.08) = 64.8

but actual price is 60 so it is undervalued and a good buy

B) calculation of terminal value after 4 years

= d5/(k-g)

= 3/(0.12-0.08) = 75

value of share will be present value of cash flows

year	dividend	pv factor @12%	product
1	2.2	0.8928	1.96416
2	2.4	0.7971	1.91304
3	2.6	0.7117	1.85042
4	2.8	0.6355	1.7794
T.v	75	0.6355	47.6625
		price	55.16952

so price is 55.16952