Question

Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 15% per year.

a. If r = 20% and DIV1 = $7, what is the value of a share? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. If r = 20% and DIV1 = $7, What price do you forecast for the stock next year? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. If r = 20% and DIV1 = $7, What rate of return should you expect if you buy the stock today and sell it in one year? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Growth Rate, g = -15%

Answer a.

Value of Share, P0 = Div1 / (r - g)
Value of Share, P0 = $7.00 / [0.20 - (-0.15)]
Value of Share, P0 = $7.00 / 0.35
Value of Share, P0 = $20.00

Answer b.

Expected Price Next Year, P1 = P0 * (1 + g)
Expected Price Next Year, P1 = $20.00 * (1 - 0.15)
Expected Price Next Year, P1 = $20.00 * 0.85
Expected Price Next Year, P1 = $17.00

Answer c.

Rate of Return = (P1 + Div1 - P0) / P0
Rate of Return = ($17.00 + $7.00 - $20.00) / $20.00
Rate of Return = $4.00 / $20.00
Rate of Return = 0.20 or 20.00%