Question

Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 5% per year. a. If r = 15% and DIV1 = $4, what is the value of a share? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. What price do you forecast for the stock next year? (Do not round intermediate calculations. Round your answer to 2 decimal places.) c. What rate of return should you expect if you buy the stock today and sell it in one year? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Next Visit question mapQuestion 7 of 10 Total 7 of 10 Prev

Answer 1

Requirement (a) - The Value of a share

Dividend in Year 1 (D1) = $4.00 per share

Dividend Growth Rate (g) = -5%

Required Rate of Return (r) = 15%

Therefore, the Value of a share = D1 / (r – g)

= $4.00 / [0.15 – (-0.05)]

= $4.00 / 0.20

= $20.00 per share

“The Value of a share = $20.00”

Requirement (b)- The price of the stock in next year

Dividend in Year 1 (D1) = $4.00 per share

Dividend Growth Rate (g) = -5%

Required Rate of Return (r) = 15%

The Price of the Stock = D1(1 + g) / (r – g)

= $4.00[1 + (-0.00)] / [0.15 – (-0.05)]

= $3.80 / 0.20

= $19.00 per share

“The price of the stock in next year = $19.00”

Requirement (c) - The Expected Rate of Return

The Expected Rate of Return = [ (Dividend per share + Capital Gain) / P0] x 100

= [{$4.00 + ($19.00 - $20.00)} / $20.00] x 100

= [($4.00 – $1.00) / $20.00] x 100

= [$3.00 / $20.00] x 100

= 15.00%

“The Expected Rate of Return = 15.00%”