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8-An investor with a required return of 10 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase
8-An investor with a required return of 10 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase. The information is as follows:
McD KFC W
Current Earnings $2.00 $3.00 $6.50
Current Dividend $1.20 $2.80 $7.00
Expected annual growth rate 5% 3% -2%
Current share prices $25 $48 $75
a) What is the maximum price that the investor should pay for each stock based on the dividend-growth model?
b) If the investor does buy stock McD, what is the implied percentage return?
c) If the appropriate P/E ratio is 12, what is the maximum price the investor should pay for each stock? Would your answers be different if the appropriate P/E were 7?
d) What does stock W's negative growth rate imply?
Expert Solution
a) Computation of the price of each stock:-
Price of stock = D1/(Required return - Growth rate)
Price of McD stock = $1.20*(1+5%)/(10%-5%)
= $1.26/5%
= $25.20
Price of KFC stock = $2.80*(1+3%)/(10%-3%)
= $2.88/7%
= $41.20
Price of W stock = $7*(1+(-2%))/(10%-(-2%))
= $6.86/12%
= $57.17
b) Computation of the implied percentage return:-
Implied percentage return = (Dividend/Price)+Growth rate
= ($1.20/$25)+5%
= 4.80% + 5%
= 9.80%
c) Computation of the price of each stock:-
P/E ratio = Price / Earning
Price = (P/E ratio)*Earnings
When P/E = 12 ;
Price of McD stock = 12*$2
= $24
Price of KFC stock = 12*$3
= $36
Price of W stock = 12*$6.50
= $78
When P/E = 7 ;
Price of McD stock = 7*$2
= $14
Price of KFC stock = 7*$3
= $21
Price of W stock =7*$6.50
= $45.50
d) Negative growth rate in stock W implies that stock will pay less dividend in future and higher required return to that extent. So, the investor should not buy it.
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