Tipton\'s stock has a required return of 12%, and the stock sells for $40 per sh

Question

Tipton's stock has a required return of 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00*(1.3)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of 5% per year forever. What is the stock’s current true value. Should you long-or-short this security? What return would you expect to obtain from your trade if the stock reverts to the correct price over a 2-year period? What type of a position is this (speculative, value capturing, growth capturing, arbitrage, broker-dealer exchange spread)?

Explanation / Answer

stock’s current true value is sum of present value of dividends received during the four years and present value of terminal value

stock’s current true value =4.91+40.80=$ 45.71

Stock is under valued as actual market price is less than expected value. Therefore, you should go for logn position i.e. buy security.

year Dividend PVF@12% PV 1 1.3 0.83 1.08 2 1.69 0.69 1.17 3 2.197 0.58 1.27 4 2.8561 0.48 1.38 4.91 Add: PV of Terminal value(2.8561/(12%-5%)} 40.80

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