Question

Consider the following stocks: • Stock A is expected to pay a dividend of £4 forever; • Stock B is expected to pay a dividend of £2 next year, £2.50 in year 2, with dividend growth expected to be 3% per annum thereafter. If the required return on similar equities is 9%, calculate the price of each stock.

Answer 1

£44.44

£40.06

Explanation:

Stock A

Price of a perpetual dividend payment = dividend / required return

4 / 0.09 = 44.44

Stock B

price is equal to the present value of the dividend

Value in the second stage of constant growth =( 2.5 x 1.03) / (0.09 - 0.03) = 42.92

Cash flow in year 1 = 2

cash flow in year 2 = 2.5 + 42.92

I = 9%

PV = 40.06

To find the PV using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. after inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute