Question

You observe Thundering Herd Common Stock selling for $40.00 per share. The next dividend is expected to be $4.00, and is expected to grow at a 5% annual rate forever. If your required rate of return is 12%, should you purchase the stock?A) no, because the present value of the expected future cash flows is greater than $40B) no, because the present value of the expected future cash flows is less than $40C) yes, because the present value of the expected future cash flows is greater than $40D) yes, because the present value of the expected future cash flows is less than $40

Answer 1

Answer:

C

Explanation:

First let calculate the stock intrinsic value to see whether is stock is overvalued or undervalued based on current market price. The stock can be valued using dividend discounted model (DDM). The DDM is stated as below:

Stock value = Next year dividend/(required rate of return - long-term growth)

                   = 4.00/(12% - 5%) = 57.14

The stock intrinsic value is higher than current market price so it is undervalued now. Correct answer is option C