*** Please Show All Work *** An investor with a required return of 14 percent fo
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Question
*** Please Show All Work ***An investor with a required return of 14 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase. The information is as follows:
Firm A B C
Current Earnings $2.00 $3.20 $7.00
Current dividend $1.00 $3.00 $7.50
Expected annual growth in dividends and earnings 7% 2% -1%
Current market price $23 $47 $60
a) What is the maximum price that the investor should pay for each stock based on the dividend-growth model?
b) If the investor does buy stock A, what is the implied percentage return?
c) If the appropriate P/E ratio is 12, what is the maximum price the investor should pay for each stock? Would your answers be different if the appropriate P/E were 7?
d) What does stock C's negative growth rate imply?
Explanation / Answer
a) maximum price that can be paid in the given conditions are: for firm a = dividend/ return from div. = 1/(0.14-0.07) = 14.3 ($) for firm b = 3/(0.14-0.02) = 25 ($) for firm c = 7/(0.14-(-0.01)) = 7/0.15 = 46.67 ($) b) return of stock A = dividend/price + growth => = 1/23 + 0.07 = 0.0435 + 0.07 = 0.1135 = 11.35% c) maximum price based on P/E =12, i.e. P = 12E, for firm a = 12*2 =24 ($) for firm b = 12*3.2 = 37.2 ($) for firm c = 12*7 = 84 ($) All prices on P/E = 12 basis exceeds based on return in part(a) above. So no stock is buyable. If P/E = 7 , max price of a, b, c = 14, 22.4, 49 respectively in ($). Hence stock a and b are buyable as they are less than that on return basis. d) negative growth of stock C implies less dividends in future and higher required returns to that extent, i.e. max price will be lower or dividend to be paid higher.
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