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

Question:

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

Here,

  • 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

Question a)

Here,

  • Sales price = $110
  • Return = 8%

The amount that can be paid for the stock is

0.08 = (110 + 6 - Cost) / Cost

Cost = $107.41

Question b)

  • 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

Price
= Expected dividend / (Return - Growth)
= 6 / 0.03
= $200


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
11K

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