Question

(Common stock valuation) The common stock of NCP paid $1.32 in dividends last year. Dividends are expected to grow at an 8% annual rate for an indefinite number ofyears.

a. If NCP’s current market price is $23.50 per share, what is the stock’s expected rate of return?

b. If your required rate of return is 10.5%, what is the value of the stock for you?

c. Should you make the investment?

Answer 1

Common stock last year dividend (D₀) = $1.32 per share

Expected dividend growth rate (g) = 8% annual rate for an indefinite number of years

(a) If NCP’s current market price is $23.50 per share, what is the stock’s expected rate of return?

Common Stock expected rate of return = [Dividend in year 1 / Stock price] + growth rate

Dividend in year 1 (D₁) = Last year dividend (D₀) [1+Dividend growth rate]

Dividend in year 1 (D₁) = $1.32 (1+0.08)

Dividend in year 1 (D₁) = $1.4256

Common stock current market price = $23.50 per share

Common stock expected rate of return = [$1.4256 / $23.50] + 0.08

Common stock expected rate of return = 0.14066 (or) 14.06%

Common stock expected rate of return = 14.06%

(b) If your required rate of return is 10.5 percent, what is the value of the stock for you?

Common stock required rate of return = 10.5%

Expected dividend growth rate (g) = 8%

Common stock last year dividend (D₀) = $1.32 per share

Dividend in year 1 (D₁) = Last year dividend (D₀) [1+Dividend growth rate]

Dividend in year 1 (D₁) = $1.32 (1+0.08)

Dividend in year 1 (D₁) = $1.4256

Common stock value = [Dividend in year 1 / (required rate of return – growth rate)]

Common stock value = [$1.4256 / (0.1050 – 0.08)]

Common stock value = [$1.4256 / 0.025]

Common stock value = $57.024

Common stock value = $57.024

(c) The expected rate of return exceeds your required rate of return, which means that the value of the security to you is greater than the current market price. Thus, you should buy the stock.