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You are thinking to buy a share of Company Ames’ stock and hold it for 3...

You are thinking to buy a share of Company Ames’ stock and hold it for 3 years. The company pays annual dividend. The dividends for the next three years are expected to be $1.2, $2, and $2.4 respectively. At the end of year 3, you expect to sell the share for $20. What is the price you are willing to pay supposed the required rate of return is 8% per year?

A. $20

B. $20.61

C. $21.20

D. $23.20

E. $19.78

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Answer #1

The current price of the stock

The Value of the Stock is the aggregate of the Present Value of the future dividend payments and the present value the stock price for the year 3

Year

Cash flow ($)

Present Value Factor (PVF) at 8.00%

Present Value of cash flows ($)

[Cash flows x PVF]

1

1.20

0.925926

1.11

2

2.00

0.857339

1.71

3

2.40

0.793832

1.91

3

20.00

0.793832

15.88

TOTAL

20.61

“Hence, the current price of the stock will be B. $20.61”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)n], Where “r” is the Discount/Interest Rate and “n” is the number of years.

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