Question

On January 2, 2016, Leahy, Inc. purchased a 25% interest in Bava Corp. for $2,000,000 cash. During 2016, Bava's net income was $3,500,000 and it paid dividends of $800,000?

Answer 1

An investor will calculate the present value of the future dividends that Babble, Inc. will pay out before it disbands to determine what to pay for a share of stock, dividing the expected profits by the sum of one plus the discount rate raised to the power of the number of years into the future, for each dividend, and then totaling these amounts for one share.

Step-by-step explanation:

When evaluating what an investor would pay for a share of stock in Babble, Inc., it's essential to consider the present value of future dividends since the company is planning to disband in two years. To arrive at the present value, we discount the expected profits—which are also the dividends in this scenario—back to their present values using a required rate of return.

Assuming the dividends are $15 million immediately, $20 million one year from now, and $25 million two years from now, and there are 200 shares, the present value of each dividend is calculated by dividing the dividend amount by (1 + r)^t, where 'r' is the discount rate and 't' is the number of years into the future. This calculation is performed for each dividend and then summed to find the total present value of the dividends for one share, which will be the price an investor is willing to pay for a share of Babble, Inc.