Question

Jenin recently purchased 100 shares of Tarifi's Optical common stock for $6,000. The stock is expected to provide an annual cash flow of dividends of $400 indefinitely. Assuming a discount rate of 8 percent, how does the price Jenin paid compare to the value of the stock?

Answer 1

Answer:

Since the present value of the perpetuity ($5,000) is less than the price that Jenin paid for the stocks ($6,000), we can conclude that she paid an excessively high price for them.

Explanation:

Jenin invested $6,000 in stocks that yield a perpetual dividend. In order to compare if Jenin made a good deal we must find the present value of the perpetuity:

present value = annual cash flow / discount rate = $400 / 8% = $5,000

Since the present value of the perpetuity is less than the price that Jenin paid for the stocks, we can conclude that she paid an excessively high price for them.