Can you show each step of how you arrive at the answer? I want to make sure I un

Question

Can you show each step of how you arrive at the answer? I want to make sure I understand exactly how you compute the final answers. Thanks!

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. Market Risk Premium is 6%. Currently, the shares of XYZ trade on the stock exchange for $3.14. If you work as an investment advisor and

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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