Question

Suppose you expect Longs Drug Stores to pay an annual dividend of $2 per share in the coming year and to trade $40 per share at the end of the year. If investments with equivalent risk to Longs' stock have an expected return of 6%, what is the most you would pay today for Longs' stock

Answer 1

The maximum price to pay for Longs' Drug Stores stock today, with an expected annual dividend of $2 and a year-end stock price of $40, considering a 6% required return, is approximately $39.62 based on the discounted cash flow model.

Step-by-step explanation:

To determine the maximum price you would pay today for Longs' Drug Stores stock, given the expected annual dividend of $2 and a projected stock price of $40 at year-end, we use the discounted cash flow model, which considers the time value of money and the required return on investment. Since the required return for an investment with equivalent risk is 6%, we can calculate the present value of the expected cash flows (which, in this case, are the dividend plus the future stock price).

Here's the formula for the present value (PV) of the future cash flows:

PV = (Dividend + Stock Price) / (1 + Required Rate of Return)

Plugging in the values:

PV = ($2 + $40) / (1 + 0.06)

So, the maximum price you would be willing to pay for Longs' stock today is:

PV = $42 / 1.06 ≈ $39.62

Therefore, under the assumption of a 6% required return, you would be willing to pay up to approximately $39.62 for Longs' Drug Stores stock today.

Answer 2

$39.62

Step-by-step explanation:

Calculation to determine what is the most you would pay today for Longs' stock

Using this formula

P0=Div1+P1/1+rE

Let plug in the formula

P0=$2+$40/(1+.06)

P0=$42/1.06

P0=$39.62

Therefore the most you would pay today for Longs' stock is $39.62