Assume you\'ve generated the following information about the stock of Bufford\'s

Question

Assume you've generated the following information about the stock of Bufford's Burger Barns: The company's latest dividends of $3.63 a share are expected to grow to $3.85 next year, to $4.08 the year after that, and to $4.32 in year 3. After that, you think dividends will grow at a constant 6 % rate.

a. Use the variable growth version of the dividend valuation model and a required return of 15 % to find the value of the stock.

b. Suppose you plan to hold the stock for three years, selling it immediately after receiving the $4.32 dividend. What is the stock's expected selling price at that time? As in part (a), assume a required return of 15 %.

c. Imagine that you buy the stock today paying a price equal to the value that you calculated in part (a). You hold the stock for three years, receiving dividends as described above. Immediately after receiving the third dividend, you sell the stock at the price calculated in part (b). Use the IRR approach to calculate the expected return on the stock over three years. Could you have guessed what the answer would be before doing the calculation?

d. Suppose the stock's current market price is actually $39.48 . Based on your analysis from part (a), is the stock overvalued or undervalued?

e. A friend of yours agrees with your projections of Bufford's future dividends, but he believes that in three years, just after the company pays the $4.32 dividend, the stock will be selling in the market for $56.79 . Given that belief, along with the stock's current market price from part (d), calculate the return that your friend expects to earn on the stock over the next three years.

Explanation / Answer

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Value of the Stock at year 3 D4/(ke-g) D4 D3*1.06 =4.32*1.06 4.5792 Ke 15% g 6% P3 4.5792/(.15-.06) 50.88 a Year Inflow Dis. Fact=1/(1+.15)^n PV 1 3.85 0.869565217              3.35 2 4.08 0.756143667              3.09 3 4.32 0.657516232              2.84 3 50.88 0.657516232            33.45 Value of the Stock            42.73 b Value of the Stock at year 3 D4/(ke-g) D4 D3*1.06 =4.32*1.06 4.5792 Ke 15% g 6% P3 4.5792/(.15-.06) 50.88 c P0 D0(Ke-g) D0 3.63 Ke 15% g 6% P0 3.63/(.15-.06)            40.33 IRR Dis factor Dis factor PV PV Year 17% 18% 17% 18% 0 -40.33 1 1      (40.33)      (40.33) 1 3.85 0.854700855 0.8474576           3.29           3.26 2 4.08 0.730513551 0.7181844           2.98           2.93 3 55.2 0.624370556 0.6086309         34.47         33.60 NPV           0.41         (0.54) IRR=17+.41/(.41+.54)*(18-17) 17.43% d Current Market price 39.48 then share is under valued by $.85 i.e. (39.48-40.33)

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