Common stock value--Zero growth: Kelsey Drums Inc is a well established supplier

Question

Common stock value--Zero growth:

Kelsey Drums Inc is a well established supplier of fine percussion instruments to orchestras all over the United States. The compnay's class A common stock has paid a dividend of $12 per share per year for the past 15 years. Management expects to continue to pay at that amount for the foreseeable future. Sally Talbot purchased 500 shares of Kelsey class A common 8 years ago at a time when the required rate of return for the stock was 11%. She wants to sell her shares today. The current required rate of return for the stock is 14%. How much total capital gain or loss will sally have on her shares?

A.) The value of stock when Sally purchased it was $? per share

B.) The value of the stock if Sally sells her shares today is $? per share

C.) The total capital gain (or loss) Sally will have on her shares is $?

Explanation / Answer

As per Dividend Discount Model,

The price of Common stock = Dividend / (r – g)

Where r = required rate of return

And g = growth rate in Dividend

Here in the zero growth rate of dividend, g = 0,

So, price of common stock = Dividend / r-0 = Dividend / r

a) The dividend when Sally purchased = $12

The required rate of return when Sally purchased = 11%

The value of stock when Sally purchased = $12 / 0.11 = $109.091

b) The dividend when Sally is about to sell = $12

The required rate of return when Sally is about to sell = 14%

The value of stock when Sally is about to sell = $12 / 0.14 = $85.714

c) Number of shares Sally purchased = 500

As the sell price is less than the purchase price, it is a capital loss.

The capital loss = (Purchase price - sell price) x Number of stocks

                               = ($109.091 - $85.714) x 500 = $11,688.3

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