Question

Shares in Brothers Grimm, Inc., manufacturers of gingerbread houses, are expected to pay a dividend of $5.00 in one year and to sell for $100 per share at that time. How much should you be willing to pay today per share of Grimm:

a. If the safe rate of interest is 5 percent and you believe that investing in Grimm carries no risk?

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b. If the safe rate of interest is 10 percent and you believe that investing in Grimm carries no risk?

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c. If the safe rate of interest is 5 percent, but your risk premium is 3 percent?

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d. Repeat parts a to c, assuming that Grimm is not expected to pay a dividend, but the expected price is unchanged.

Answer 1

The share of any company gives the ownership right to the buyer of share. The buyer will receive a regular payment on the share called dividend. The dividend is decided on the basis of company’s profit in a year. The buyer will also receive returns in terms of change in value of share in the market.

Demand for the share in the stock market depends on various factors which are as follows:

1. Dividend

2. Risk premium

Dividend and demand of share have direct relation as dividend is a return to stockholder on his investment in share. Risk premium and demand of share are negatively related as higher risk will make share less worthy. No one wants to buy a share with high risk unless a high dividend is paid as an incentive.

a.

A share of BG, Inc. expected to pay a dividend of $5 per year and $100 at the time of sale of share. The following information has been given in the question:

The present value of the share can be calculated as follows:

Hence, person A will be willing to pay for each share of BG, Inc.

b.

The following information has been given in the question:

The present value of the share can be calculated as follows:

The high safe rate of interest will decrease the amount person A is willing to pay for a share of BG, Inc. Hence, person A will be willing to pay for each share of Mr. G, Inc.

c.

The following information has been given in the question:

The present value of the share can be calculated as follows:

The higher risk premium will reduce the stock price. Hence, person A will be willing to pay for each share of BG, Inc.

d.

The following information has been given in the question:

The present value of the share can be calculated as follows:

Hence, person A will be willing to pay for each share of Mr. G, Inc.

The following information has been given in the question:

The present value of the share can be calculated as follows:

Hence, person A will be willing to pay for each share of Mr. G, Inc.

The following information has been given in the question:

The present value of the share can be calculated as follows:

Hence, person A will be willing to pay for each share of Mr. G, Inc.