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Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your...

Question:

Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

a) $164.19

b) $75.29

c) $107.53

d) $118.35

e) $131.74

Dividend Growth Model:

The dividend growth model is a stock valuation model that calculates the fair market value of the stock based on its expected dividend in the future. However, the downside of this model is that it excludes the potential changes in the financial capability of the firm, as seen in its financial ratios.

Answer and Explanation:

Formula on calculating the amount that should be paid to the stock:

{eq}Price=\frac{D+P}{(1+r)^{n}}\\ whereas:\\ D=dividend\\ P=expected~price\\ r=interest~rate\\ n=number~of~periods\\ {/eq}

{eq}\begin{align*} Price&=\frac{9.25+150}{(1+.16)^{2}}\\ &=\frac{159.25}{1.3456}\\ &=118.35\\ \end{align*} {/eq}

The maximum price that should be paid to the stock to earn a required return of 16% is D. $118.35


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
9.8K

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