Question

The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $135 a year from now. Do not round intermediate calculations. Round your answers to the nearest cent.

1. If you require 11 percent on this stock, how much would you be willing to pay for it?

   $  

2. If you expect a selling price of $109 and require an 8 percent return on this investment, how much would you pay for the BBC stock?

   $  

Answer 1

a. The price is computed as follows:

= [ Earning per share next year x (Dividend paid last year / Earnings last year) ] / (1 + required rate of return) + Selling price of stock a year from now / (1 + required rate of return)

= [ $ 11 x ($ 6 / $ 10) ] / 1.11 + $ 135 / 1.11

= $ 6.6 / 1.11 + $ 135 / 1.11

= $ 127.57

b. The price is computed as follows:

= [ Earning per share next year x (Dividend paid last year / Earnings last year) ] / (1 + required rate of return) + Selling price of stock a year from now / (1 + required rate of return)

= [ $ 11 x ($ 6 / $ 10) ] / 1.08 + $ 109 / 1.08

= $ 6.6 / 1.08 + $ 109 / 1.08

= $ 107.04

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