Question

Consider the following three stocks:

Stock A is expected to provide a dividend of $11.20 a share forever.
Stock B is expected to pay a dividend of $6.20 next year. Thereafter, dividend growth is expected to be 6.00% a year forever.
Stock C is expected to pay a dividend of $4.80 next year. Thereafter, dividend growth is expected to be 22.00% a year for five years (i.e., years 2 through 6) and zero thereafter.

Required:
If the market capitalization rate for each stock is 10%, which stock is the most valuable?

Answer 1

Stock B is most valuable

Step-by-step explanation:

a. Price of Stock A = $11.20/10% =$11.20/0.1 = $112

b. Price of Stock B = $6.20 / (10%-6%) = $6.20/4% = $6.20/0.04 = $155

C. Price of Stock C = $4.80/1.1 + $4.80*1.22/1.11^2 + $4.80*1.22^2/1.11^3 + $4.80*1.22^3/1.11^4 + $4.80*1.22^4/1.11^5 + ($4.80*1.22^5/10%)/1.1^5

Price of Stock C = $4.36 + $4.75 + $5.22 + $5.74 + $6.31 + $80.55

Price of Stock C = $106.93

Conclusion: Stock B is most valuable