• Another investment opportunity available to your company involves the purchase

Question

• Another investment opportunity available to your company involves the purchase of some common stock from Zorp Corporation. The company has asked you to evaluate the stock, which paid a dividend of $4.25 last year and is currently selling for $36 per share. If your company decides to buy the stock, the stock will be held for 5 years and then sold. The growth rate on the stock is constant at 3% per year, and your company's required return on the stock would be 11%. What is the maximum price per share that your company should pay for the stock?

Explanation / Answer

Given,

Dividend (D0) = $4.25

Growth Rate (g) = 3 %

Required Return (r) = 11 %

P0= D0 (1+g)/(r-g) = 4.25 * 1.03 /(0.11 - 0.03)

= 4.3775/0.08 = $54.72

With required rate of return of 11 % and constant growth of 3 % , maximum price that company can pay is $54.72.

With current price of $36 ; company should purchase the stock

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