Question

Honeywag common stock is expected to pay $1.85 in dividends next year, and the market price is projected to be $42.50 per share by year-end. If investors require a rate of return of 11 percent, what is the current value of the stock?

Answer 1

Answer:

Current Price = $39.79275 rounded off to $39.79

Explanation:

Using the constant growth of dividend model, we can calculate the price of the stock at any time. The formula for price today under this model is,

P0 = D0 * (1+g) / (r - g)

Where,

• Do is dividend today
• g is the growth rate
• r is the required rate of return

As we have P1, D1 and r available, we can use this to calculate the growth rate in dividends. We will use the following formula to calculate the price today.

Price today = Future price * (1 - g)

First we calculate the growth rate using P1, D1 and r in the constant growth rate formula.

42.5 = 1.85 * (1+g) / (0.11 - g)

42.5 * (0.11 - g) = 1.85 + 1.85g

4.675 - 42.5g = 1.85 + 1.85g

4.675 - 1.85 = 1.85g + 42.5g

2.825 = 44.35g

2.825 / 44.35 = g

g = 0.063697 or 6.3697% rounded off to 0.0637 or 6.37%

Now we calculate the current price of the stock to be,

Current Price = 42.5 * (1 - 0.0637)

Current Price = $39.79275 rounded off to $39.79