ABC corporation stock is selling for Rs. 150 per share according to Karachi stock exchange market summary. A rumor about the company has been heard that the firm will make an exciting new product announcement next week. By studying the industry, it is being concluded that this new product will support a growth rate of 20% in dividend for two years. After that it is expected that the growth rate in dividend will decline to 6% and remains same onwards. The firm currently pays an annual dividend of Rs. 4.
The rate of return on stocks like ABC Corporation is 10%.
Required:
I. Find out the values for D1, D2 and D3 (8 Marks)
II. What will be the price of stock (P2) at the end of year 2? (4 Marks)
III. What will be the present value (P0) of stock? (6 Marks)
IV. Should we buy stocks of ABC Corporation at Rs. 150? (2 Marks)
Solution
Find out the values for D1, D2 and D3
D1= 4 (1+0.2) =4.8
D2= 4.8 (1+0.2) =5.76
D3=5.76 (1+0.05) =6.11
What will be the price of stock (P2) at the end of year 2?
P2= 5.76 (1+0.2)/ .1-0.05
P2=138.24
What will be the present value (P0) of stock?
PO= 4.8/(1+.1)1 + 5.76/(1+.1)2 + 6.11/(1+.1)3 + 128.31/(1.1)3
= 110
Should we buy stocks of ABC Corporation at Rs. 150
As the present value of the stock is less then the current selling price so the stock should not be purchased.
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