Assume there are three companies that in the past year paid exactly the same ann

ID: 2509312 • Letter: A

Question

Assume there are three companies that in the past year paid exactly the same annual dividend of $2.172.17 a share. In? addition, the future annual rate of growth in dividends for each of the three companies has been estimated as? follows: ?

This Question: 1 pt 15 of 30 (18 complete) This Test: 30 pts possible spreadsheet.) Steady Freddie, Inc g = 896 Buggies-Are-Us Gang Buster Group $2.44 2.74 3.08 3.46 Year 1 Year 2 (i.e., dividends are expected to remain at $2.17/share) (for the foreseeable future) ear 3 Year 4 Year 5 and beyond: g 8% Assume also that as the result of a strange set of circumstances, these three companies all have the same required rate of return (r= 12%). a. Use the appropriate DVM to value each of these companies. b. Comment briefly on the comparative values of these three companies. What is the major cause of the differences among these three valuations? a. For Buggies-Are-Us, the value of the company's common shares is S (Round to the nearest cent.) For Steady Freddie, Inc., the value of the company's common shares is S(Round to the nearest cent.) For Gang Buster Group, the value of the company's common shares is (Round to the nearest cent.)

Explanation / Answer

a. The value of stock of each company is as under:

Buggies Are US

Since it is a no growth company, the value of its stock will be

Dividend / Required Rate of Return

= 2.17/0.12

=$18.08

Steady Freddie Inc

Since it is a constant growth company, the value of stock will be

Dividend for year 1/ (RE – Growth)

= 2.17(1+0.08)/(0.12 -0.08)

=2.3436/0.04

= $58.59

Gang Buster Group

In this company growth rate is different till year 4 and constant from year 5 onwards. So we will find the value of its stock in two stages:

Stage 1 ( Multiple Growth )

Year

Dividend

Discounting Factor@12%

Discounted Cash Flow

$2.44

0.893

2.179

$2.74

0.797

2.184

$3.08

0.712

2.193

$3.46

0.636

2.201

Total

8.757

Stage 2 (Constant Growth)

Stock Value at the end of Year 4 = Dividend for year 5/(RE – Growth)

=3.46(1.08)/(0.12-0.08)

=3.7368/0.04

=$93.42

Stock Value as at Year 0 = 93.42 * Discounting Factor for year 4 = 93.42 * 0.636 = $59.415

Total Value as at Today for Gang Buster Group = $8.757(Stage1) + $59.415(Stage 2) = $68.17

b. On comparing the three companies , it is found that difference among these three valuations is due to the difference in dividend growth rates.

Hence the correct answer is option A.