Company XYZ is expected to pay no dividends for the next 10 years (that is, up t

Question

Company XYZ is expected to pay no dividends for the next 10 years (that is, up to, and including Year 10). In year 11, the company will pay a dividend of $0.75. After that, all subsequent dividends will be growing at 5.5% per year forever. Company XYZ has estimated beta of 1.2, and the risk-free rate is supposed to be constant 5% per year forever. Currently, the shares of XYZ trade on the stock exchange for $3.14. Market Risk Premium = 6%. If you work as an investment advisor and

(1) Your client owns no XYZ shares

Explanation / Answer

Ke = Rf + Marker Risk Premium * Beta = 5 + 6 * 1.2 = 12.2%

Theoretical Price of Share = 0.75 / (0.122 - 0.055) * PVF(12.2%, 11years) = $3.16

A) The share is undervalued by $0.02. Thus, we will advise the client that he should purchase the share now.

B) NO, we will not advise the client to sell the share since it is undervalued by $0.02 and it would be better to hold the share.

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