ABC corporation stock is selling for Rs. 150 per share according to Karachi stoc
ID: 2435201 • Letter: A
Question
ABC corporation stock is selling for Rs. 150 per share according to Karachi stock exchange market summary. A rumor about the company has been heard that the firm will make an exciting new product announcement next week. By studying the industry, it is being concluded that this new product will support a growth rate of 2% in dividend for two years. After that it is expected that the growth rate in dividend will decline to 6% and remains same onwards. The firm currently pays an annual dividend of Rs. 4. The rate of return on stocks like ABC corporation is 10%. Requited: Find out the values for D1, D2 and D3 What will be the price of stock (P2) at the end of year 2? What will be the present value (P0) of stock? Should we buy stocks of ABC Corporation at Rs. 150?Explanation / Answer
According to the given data, P0 = Rs.150 Growth rate in the first two years is 20% Growth rate from the third year will decline to 6% Dividend (D0) = Rs.4 Rate of return (r) = 10% 1) D1 = D0 (1+g) But g = 20% or 0.20 in the first two years D1 = 4 ( 1+0.2) = 4 (1.2) = Rs 4.8 D2 = D1 ( 1+ g)] = 4.8 ( 1+ 0.2) = 4.8 (1.2) = 5.76 D3 = D2 ( 1+g) But g = 6% or 0.06 D3 = 5.76 (1+0.06) = 5.76 (1.06) = Rs 6.1056 Therefore, the dividends in the year-1 are Rs 4.8, year-2 are Rs. 5.76; year-3 are Rs. 6.1056 2) The formula for calculating the price of the stock is P0 = (D1 /r - g) To calculate the price (P2) at the end of year-2 is P2 = (D3 / r - g) Where D3 = 6.1056 r = 10% g = 6% Substituting the values in the above formula, we get P2 = 6.1056 / (0.10 - 0.06) = 6.1056 / 0.04 = Rs. 152.64 Therefore, the price (P2) at the end of year-2 is Rs. 152.64 3) The given problem is a model of non-constant growth The formula for calculating the price (P0) for this model is P0 = D1 / (1+ r)^1 + D2 / (1+r)^2 + D3 / ( 1+ r)^3 + P3 / (1+r)^3 We know the values of D1, D2, D3 but we dont know the value of P3 P3 = D4 / (r - g) where D4 = D3 ( 1+g) = 6.1056 ( 1+ 0.06) = 6.1056 (1.06) = 6.47 P3 = 6.47 / (0.1 - 0.06) = 6.47 / 0.04 = Rs. 161.75 Therefore, the value of P3 is Rs. 161.75 P0 = 4.8 / (1+0.1)^1 + 5.76 / (1+0.1)^2 + 6.1056 / (1+0.1)^3 + 161.75 / (1+0.1)^3 = (4.8 / 1.1) + (5.76 / 1.21) + (6.1056 / 1.331) + (161.75 / 1.331) = 4.36 + 4.76 + 4.58 + 121.5 = Rs. 135.2 Therefore, the present value of the stock is Rs. 135.2 4) No, we shouldn't buy the stock at Rs.150 because the present value of the stock is only Rs. 135.2. The stock is overpriced and therefore we shouldn't buy the stock.