1. The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a...

Question:

1. The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $132 a year from now. If you require 12 percent on this stock, how much would you be willing to pay for it?

2. Given the expected earnings and dividend payments in Problem 1, if you expect a selling price of $110 and require an 8 percent return on this investment, how much would you pay for the BBC stock?

3. Over the long run, you expect dividends for BBC in Problem 1 to grow at 8 percent and you require 11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?

Dividend Growth Model:

The dividend growth model is a stock valuation model that is used to determine the value of a stock. The model assumes that the present value of the future dividends expected to be issued on the stock discounted at the required return less the growth rate to be the current stock price or the intrinsic value of the stock. The model also assumes the dividends to grow at a constant growth rate to perpetuity.

Answer and Explanation:


Answer:

1) The amount that can be paid for BBC's stock is $123.75.

Explanation:

As per the data:

  • Current EPS = $10
  • Expected EPS = $11
  • Current dividend, D0 = $6
  • Expected market price, P1 = $132
  • Required return, Ke = 12%

Computation:

The price that can be paid is equal to the present value of future cash flows from the stock which is the future dividend and the share price in year 1.

  • Current share price = {eq}D1/ (1 + Ke)^1 + P1 / (1 + Ke)^1 {/eq}
  • Current share price = {eq}$6.6 / (1 + 0.12) + $132 / (1 + 0.12) {/eq}
  • Current share price = {eq}$123.75 {/eq}

Working Note:

  • Dividend payout ratio = Dividend / EPS
  • Dividend payout ratio = $6 / $10
  • Dividend payout ratio = 60%

And,

  • Dividend next year, D1 = EPS in year 1 * Dividend payout ratio
  • Dividend next year, D1 = $11 * 60%
  • Dividend next year, D1 = $6.60


2) The amount that can be paid for BBC's stock is $107.96.

Explanation:

As per the data:

  • Expected market price, P1 = $110
  • Required return, Ke = 8%

Computation:

The price that can be paid is equal to the present value of future cash flows from the stock which is the future dividend and the share price in year 1.

  • Current share price = {eq}D1/ (1 + Ke)^1 + P1 / (1 + Ke)^1 {/eq}
  • Current share price = {eq}$6.6 / (1 + 0.08) + $110 / (1 + 0.08) {/eq}
  • Current share price = {eq}$107.96 {/eq}


3) The amount that can be paid for BBC's stock is $220.

Explanation:

As per the data:

  • D1 = $6.60
  • Growth rate, g = 8%
  • Required return, Ke = 11%

Computation:

Under the dividend growth model.

  • P0 = D1/(Ke - g)
  • P0 = $6.60 / (11% - 8%)
  • P0 = $220

Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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