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?
a) Given the expected earnings and dividend payments, 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?
b). Over the long run, you expect dividends for BBC 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?
Return on Investment and Dividend Growth Model:
Return on investment is given as the earnings generated by investing in a financial instrument. Dividend growth model helps in identifying the share value given a constant growth rate in dividends.
Answer and Explanation:
The return on investment (ROI) can be calculated as
Return on Investment = (Sales Price + Dividends - Purchase price) / Purchase price x 100
- Sales Price = $132.00
- Dividends = $6.00
- Return on Investment = 12%
- Purchase price = Cost to be paid
So, substituting the values in the formula, we get
12% = (132 + 6 - Cost) / Cost x 100
0.12 x Cost = 138 - Cost
Cost = 138 / 1.12 = $123.21
- Sales price = $110
- Return = 8%
The amount that can be paid for the stock is
0.08 = (110 + 6 - Cost) / Cost
Cost = $107.41
- Expected dividend = $6.00
- Growth rate = 8% = 0.08
- Required return = 11% = 0.11
As per DDM, the amount that can be paid for the stock is
= Expected dividend / (Return - Growth)
= 6 / 0.03
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Learn more about this topic:
from Finance 101: Principles of FinanceChapter 14 / Lesson 3