DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have been declared as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its supernormal growth. After that, dividends are expected to grow at the firm's normal growth rate of 6 percent. The firm's required rate of return is 18 percent. The stock is

Question

Quizplus · Accepted Answer

First, we need to calculate the expected dividend at the end of year 3 using the formula:

Expected Dividend at the end of year 3 = Dividend at the end of year 2 x (1 + Normal growth rate)

Expected Dividend at the end of year 3 = $2.00 x (1 + 0.06) = $2.12

Next, we need to calculate the present value of all the dividends from year 4 onwards using the formula:

Present value of dividends from year 4 onwards = (Expected dividend at the end of year 3 / (Required rate of return - Normal growth rate))

Present value of dividends from year 4 onwards = ($2.12 / (0.18 - 0.06)) = $13.33

Then, we need to calculate the present value of all the dividends and the expected stock price at the end of year 3 using the formula:

Present value of all dividends and expected stock price at the end of year 3 = (Expected stock price at the end of year 3 + Present value of dividends from year 4 onwards) / (1 + Required rate of return) ^ 3

Expected stock price at the end of year 3 = (Current stock price x (1 + Growth rate) ^ n) = $26.51

Present value of all dividends and expected stock price at the end of year 3 = ($26.51 + $13.33) / (1 + 0.18) ^ 3 = $24.78

Finally, we compare the present value of all the dividends and the expected stock price at the end of year 3 with the current stock price to determine if the stock is undervalued or overvalued.

If the current stock price is less than the present value of all the dividends and the expected stock price at the end of year 3, then the stock is undervalued. If the current stock price is greater than the present value of all the dividends and the expected stock price at the end of year 3, then the stock is overvalued.

In this case, the current stock price is $15, which is less than the present value of all the dividends and the expected stock price at the end of year 3 ($24.78). Therefore, the stock is overvalued by $3.03.

DAA's Stock Is Selling for $15 Per Share