Question

a. The broker offers to sell you some shares of ABC & Co. common stock that paid annual dividend of $2.00 yesterday. ABC’s dividend is expected to grow at 5% per year for the next 3 years. If you buy the stock, you plan to hold it for 3 years and then sell it. The appropriate discount rate is 12%.

From the perspective of either an investor and firm, which of the financing ways is preferable? Debt or equity? Please justify your choice with relevant reasons (Not more than 200 words).

Answer 1

Using Dividend Discount Modal:

Value of stock today = Expected Dividend for next year / (Discount Rate - Growth Rate)

Value of stock today = D₀(1+g) / (K_e - g)

D₀ = Dividend paid yesterday (last)

g = Annual Growth Rate

Ke = Discount Rate

So the value of stock:

= $2 (1.05) / (0.12-0.05)

Value = $30 per share

Question 2)

From the perspective of investors - Equity is more favourable as it gives them right to participate in profits and upside in valuations

From perspective of firm - Mix combination of debt and equity is favourable as debt comes at cheaper cost and equity doesnt have any fixed cost associated with them, so a combination of two is helpful to grow and leverage