Question

Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $8.25 at the end of Year 2. In addition, you expect to sell the stock for $100 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

Answer 1

Solution:         

Statement showing calculation of amount payable for the stock today

Sl.No.	Particulars	Year	Cash Flow	PVF @ 16 %	Discounted Cash Flow
1	Dividend	2	$ 8.25	0.7432	$ 6.1314
2	Maturity Amount	2	$ 100	0.7432	$ 74.3200
3	Amount payable for the stock today				$ 80.4514
4	Amount payable for the stock today ( when rounded off to two decimal places)				$ 80.45

Note :

The formula for calculating PV Factor = 1 / ( 1 + r )ⁿ  , where r = expected rate of return = discount rate ; n= Year

The PV Factor at 16 % for year 1 = 1 / (1 + 0.16)¹ = 0.8621

The PV Factor at 16 % for year 2 = 1 / (1 + 0.16)² = 0.7432