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Homework answers / question archive / 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

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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. 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? 

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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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