Elk county telephone has paid the dividends shown in the following table over the previous 6 years
|Year||Dividend per share|
a). If you can earn 12 % on similar-risk investments, what is the most you would be willing to pay per share?
b). If you can earn only 9% on similar-risk investments, what is the most you would be willing to pay per share?
c). Compare your findings in parts a and b, what is the impact of changing risk on share value?
IThe Risk-Return Relationship:
When people buy high-risk security they anticipate compensation in the form of even higher returns. So, if investors are willing to bear the impact of risk and have the capacity for doing so they go for high earning stock. However, even then, they go for a thorough trend analysis of such securities.
Answer and Explanation:
a. The average growth rate for dividends is determined as 4% approx. ($5.2-$5/$5). So if the required return is 12%, then:
P0 = D1/Ke-g
P0 = $6.08 x 1.04/0.12-0.04
b. If the required rate of return is only 9%,
P0 = $6.08 x 1.04/0.09-0.04
c. As the required return decreases, the value of share increases. The risk-return relationship clearly states that the more risk you take, the more you are likely to earn a higher return.
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from Finance 101: Principles of FinanceChapter 14 / Lesson 3