Question

You are evaluating a stock for purchase. You estimate that the firm will pay the following dividends in the coming years:
Year 1: $2.00
Year 2: $2.50
Year 3: $3.00
After the third year the dividend is expected to grow at a long-term rate of 8%. Your required rate of return is 10%.
A. (10 pts) What is the intrinsic value of this stock?
B. (5 pts) Assume that the current price of the stock is $120. Should you purchase the stock? Explain.
C. (5 pts) If you purchase the stock at $120 and your estimates (of future dividends and prices) are
correct, what is the expected rate of return on your investment?

Answer 1

Year	expected dividend
1		2
2		2.5
3		3.5
4	3.5*1.08	3.78
terminal value of stock	expected dividend in year 4 /(required return-growth rate)	3.78/(10%-8%)	189
Year	cash flow	present value of cash flow = cash flow/(1+r)^n r= 10%
1	2	1.818182
2	2.5	2.066116
3	3	2.253944
3	189	141.9985
Intrinsic value of stock		148.14
Yes I would purchase the stock as its intrinsic value is 148.14 while its market price is 120 and stock is undervalued so it is preferable to buy the stock
exxpected rate of return = Intrinsic value/market price = (148.14-120)/120	23.45%