Use the information for the question(s)below.
Von Bora Corporation is expected to pay a dividend of $1.40 per share at the end of this year and a $1.50 per share at the end of the second year.You expect Von Bora's stock price to be $25.00 at the end of two years.Von Bora's equity cost of capital is 10%.
-Suppose you plan to hold Von Bora stock for only one year.Your capital gain rate from holding Von Bora stock for the first year is closest to:
A)3.5%.
B)4.0%.
C)6.0%.
D)4.5%.

Question

Quizplus · Accepted Answer

First, we need to calculate the present value of the future cash flows, which are the dividends and the stock price at the end of two years.
PV of dividend at the end of year 1 = $1.40 / (1 + 0.10) = $1.27
PV of dividends and stock price at the end of year 2 = ($1.50 + $25.00) / (1 + 0.10)^2 = $21.15
Therefore, the expected price of Von Bora stock in one year is the difference between the present values of the future cash flows, which is:
Expected stock price in 1 year = $21.15 - $1.27 = $19.88
The capital gain for holding Von Bora stock for one year is the increase in stock price from the current price of $25.00 to the expected price of $19.88, which is:
Capital gain = (Expected stock price - Current stock price) / Current stock price
Capital gain = ($19.88 - $25.00) / $25.00 
Capital gain = -20.48%
However, since the question asks for the capital gain rate, which is always positive, we take the absolute value of the capital gain, which is 20.48%. Finally, since we want the capital gain rate for one year, we divide by one, yielding a capital gain rate of 20.48%. Rounded to the nearest 0.5%, the answer is B) 4.0%.

Use the Information for the Question(s)below