Challenge Problem Template
1. Fasco Industries just paid a dividend of D0 = $1.45. Analysts expect the company's dividend to grow by 28% this year, by 11% in Year 2, and at a constant rate of 6% in Year 3 and thereafter. The required return on this low-risk stock is 11.00%. What is the best estimate of the stock's current market value?
2. Why are cash flows that are connected to common stock difficult to estimate? How does this compare to those related to bonds.
Problem: Fasco Industries
Return on Stock (Rs) = 11.00% notes
Stock Price = the Sum of the Present Value of All Future Dividends
P0(price today) = 1.85/1.11^1 + 2.05/1.11^2 + 43.40/1.11^2 = $38.55
| Year |
|
0 |
1 |
2 |
3 |
|
|
|
|
|
|
| Growth Rates |
|
28.00% |
11.00% |
6.00% |
|
|
|
|
|
|
| Dividend |
|
$ 1.45 |
$ 1.86 |
$ 2.06 |
$ 2.18 |
|
|
|
|
|
|
| Value in T2 = D3/(r-g3) |
|
|
$ 43.68 |
|
|
|
|
$ 1.86 |
$ 45.74 |
|
| Total Cash Flows |
|
|
|
|
|
|
|
|
|
|
| PV of Cash Flows |
|
|
|
|
| PV = FV/(1 + i)^n |
|
$1.67 |
1.67 |
|
| Here i = r |
|
|
|
|
|
Estimated Stock Price =
2. Why are cash flows that are connected to common stock difficult to estimate? How does this compare to those related to bonds. Cash flows connected to common stock are difficult to estimate because you will always have to make assumptions about the growth rate of the earnings meanwhile, bond cash flows are set at time of issue (at Face Value times the coupon rate).