Do the computations for the example below. Show the computations step by step, s

Question

Do the computations for the example below. Show the computations step by step, so Mr. Hillbrandt can easily follow your examples. 1. The company’s common stock dividends are anticipated to grow at a constant 5.5% growth rate per year going forward. The company just paid an annual dividend (that is, D-zero) of $3 per share. What’s the intrinsic value of the stock based on the following required rates of return? 1.6% 2.8% 3.10% 4.12% 2. If the stock is currently selling for $40 per share, is the stock a good buy? Interpret the results and justify your decision. 3. The company just paid an annual dividend of $1.50 per share. Dividends are anticipated to grow at a stable rate of 10% per year forever. The stock’s beta is 1.2, the risk-free rate is 4%, and the expected return on the overall stock market is 11%. What is the intrinsic value of the company’s common stock?

Explanation / Answer

Solution: The Gordon growth model relates the value of a stock to its expected dividends in the next time period, the cost of equity and the expected growth rate in dividends.

Value of stock = Dividend next time period/ (cost of equity – growth rate in dividends)

Dividend = $3

Dividend growth rate = 5.5 %

Cost of equity = 1.2 %, 2. 8 %

Value is negative, the limitation of model

Cost of equity = 10 %

Value = 3/ (0.1 – 0.055) = $ 66.67

Cost of equity = 12 %

Value of the stock = 3/(0.12 – 0.055) = $46.15

If the stock is currently selling at $40, it is available at discount to its intrinsic value of $66.67 (required rate of return 10 %) and $46.15 (required rate of return 12 %). Yes, it is a good buy.

3) Dividend = $1.5

Expected growth rate on dividend = 10 %

Required rate of return (cost of equity) = Rf + (Rm –Rf)

= risk free rate + (risk premium)

= 4 % + 1.2 * (0.11 – 0.04)

=0.124 or 12.4 %

Value of the stock = 1.5/ (0.124 – 0.1)

= $ 62.5

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