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Practice Questions CH08-Answers

The document contains 6 questions and answers related to calculating stock prices using the constant growth dividend model. Some key details: - Question 1 calculates the current and future stock prices of a company paying dividends growing at 6% annually, requiring an 11% return. The current price is $30.74, and prices in 3 and 15 years are $36.61 and $73.67 respectively. - Question 2 calculates the required return on a stock given the current price of $38 and a dividend of $1.89 growing at 5% annually, finding the required return is 9.97%. - Question 3 finds the required return on a stock with a dividend yield of 6.3% and perpetual

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136 views3 pages

Practice Questions CH08-Answers

The document contains 6 questions and answers related to calculating stock prices using the constant growth dividend model. Some key details: - Question 1 calculates the current and future stock prices of a company paying dividends growing at 6% annually, requiring an 11% return. The current price is $30.74, and prices in 3 and 15 years are $36.61 and $73.67 respectively. - Question 2 calculates the required return on a stock given the current price of $38 and a dividend of $1.89 growing at 5% annually, finding the required return is 9.97%. - Question 3 finds the required return on a stock with a dividend yield of 6.3% and perpetual

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Questions set CH08-Answers

1. The Stopperside Wardrobe Co. just paid a dividend of $1.45 per share on its stock.
The dividends are expected to grow at a constant rate of 6 percent per year
indefinitely. If investors require an 11 percent return on The Stopperside Wardrobe
Co. stock, what is the current price? What will the price be in three years? In 15
years?

The constant dividend growth model is:


Pt = Dt × (1 + g) / (R – g)
So the price of the stock today is:
P0 = D0 (1 + g) / (R – g) = $1.45 (1.06) / (.11 – .06) = $30.74
The price in 3 years:
P3 = D3 (1 + g) / (R – g) = D0 (1 + g)4 / (R – g) = $1.45 (1.06)4 / (.11 – .06) =
$36.61
The price in 15 years:
P15 = D15 (1 + g) / (R – g) = D0 (1 + g)16 / (R – g) = $1.45 (1.06)16 / (.11 – .06) =
$73.67
There is another feature of the constant dividend growth model: The stock price
grows at the dividend growth rate. So, if we know the stock price today, we can
find the future value for any time in the future we want to calculate the stock price.
In this problem, we want to know the stock price in three years, and we have
already calculated the stock price today. The stock price in three years will be:
P3 = P0(1 + g)3 = $30.74(1 + .06)3 = $36.61
And the stock price in 15 years will be:
P15 = P0(1 + g)15 = $30.74(1 + .06)15 = $73.67
2. The next dividend payment by Kilbride Inc. will be $1.89 per share. The dividends
are anticipated to maintain a 5 percent growth rate forever. If the stock currently
sells for $38.00 per share, what is the required return?

We need to find the required return of the stock. Using the constant growth
model, we can solve the equation for R. Doing so, we find:
R = (D1 / P0) + g = ($1.89 / $38.00) + .05 = .0997, or 9.97%

3. Glenhill Co. is expected to maintain a constant 5.2 percent growth rate in its
dividends indefinitely. If the company has a dividend yield of 6.3 percent, what is
the required return on the company's stock?
The required return of a stock is made up of two parts: The dividend yield and
the capital gains yield. So, the required return of this stock is:
R = Dividend yield + Capital gains yield = 0.063 + 0.052 = 0.115 or 11.50%

4. Goulds Corp. pays a constant $9.75 dividend on its stock. The company will
maintain this dividend for the next 11 years and will then cease paying dividends
forever. If the required return on this stock is 10 percent, what is the current share
price?
The price of any financial instrument is the PV of the future cash flows. The future
dividends of this stock are an annuity for 11 years, so the price of the stock is the
PVA (PV of an annuity), which will be:
P0 = $9.75(PVIFA10%,11) = $63.33
PVIFA10%,11 = 1/10% (1-(1/1.1)11)

5. Big Pond Inc. has an issue of preferred stock outstanding that pays a $4.75
dividend every year in perpetuity. If this issue currently sells for $93 per share,
what is the required return?

The price a share of preferred stock is the dividend divided by the required return.
This is the same equation as the constant growth model, with a dividend growth
rate of zero percent. Remember, most preferred stock pays a fixed dividend, so
the growth rate is zero. Using this equation, we find the price per share of the
preferred stock is: R = D/P0 = $4.75/$93 = .0511, or 5.11%
6. Kelligrews Inc. has an odd dividend policy. The company has just paid a dividend
of $3 per share and has announced that it will increase the dividend by $5 per
share for each of the next five years, and then never pay another dividend. If you
require an 11 percent return on the company's stock, how much will you pay for a
share today?

The price of a stock is the PV of the future dividends. This stock is paying 5 more
dividends, so the price of the stock is the PV of these dividends using the required
return. The price of the stock is:
P0 = $8 / 1.11 + $13 / 1.112 + $18 / 1.113 + $23 / 1.114 + $28 / 1.115 = $62.69

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