You have a 2-year investment horizon and are planning to purchase GG Co. You believe you can sell...

Question:

You have a {eq}2 {/eq}-year investment horizon and are planning to purchase GG Co. You believe you can sell this stock for {eq}\$50 {/eq} two years from now, and it will pay a dividend of {eq}\$1 {/eq} this year and {eq}\$1.10 {/eq} next year. For a {eq}14 \% {/eq} discount rate, what is the maximum you should pay for GG Co.?

Present value:

Present value can be used to make an investment decision by knowing the worth of investment in today's term by discounting the value at an assumed rate of return and for at an assumed time period.

Answer and Explanation:


We will calculate the present value of all the cash inflows with the help of following formula:

{eq}\displaystyle\text{Present value} = \displaystyle\left (\frac{\text{Future value}}{1 + {\text{Discount rate}}} \right )^{\text{Number of periods}} {/eq}


{eq}\displaystyle\text{Present value of this year dividend} = \displaystyle\left (\frac{\$1}{1 + 0.14} \right )^{1} = \$0.877193 {/eq}

{eq}\displaystyle\text{Present value of next year dividend} = \displaystyle\left (\frac{\$1.10}{1 + 0.14} \right )^{2} = \$0.846414 {/eq}

{eq}\displaystyle\text{Present value of selling price} = \displaystyle\left (\frac{\$50}{1 + 0.14} \right )^{2} = \$38.473376 {/eq}


Therefore,

The maximum amount to be paid is (0.877193 + 0.846414 + 38.473376) = $40.197.


Learn more about this topic:

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How to Calculate Present Value of an Investment: Formula & Examples

from Introduction to Business: Homework Help Resource

Chapter 24 / Lesson 15
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