You observe Thundering Herd Common Stock selling for $40.00 per share.The next dividend is expected to be $4.00,and is expected to grow at a 5% annual rate forever.If your required rate of return is 12%,should you purchase the stock?

Question

Quizplus · Accepted Answer

The present value of the expected future cash flows can be calculated using the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend), which is $ P = \frac{D_1}{r - g} $, where $ P $ is the price, $ D_1 $ is the next dividend, $ r $ is the required rate of return, and $ g $ is the growth rate. Plugging in the given values, $ P = \frac{4}{0.12 - 0.05} = \frac{4}{0.07} = 57.14 $. Since $57.14 is greater than $40, it means the stock is undervalued based on the model, and it would be a good decision to purchase the stock.

You Observe Thundering Herd Common Stock Selling for $40