Problem 5 A person is considering buying the stock of two home health companies

Question

Problem 5 A person is considering buying the stock of two home health companies that are similar in all respects except for the proportion of earnings paid out as dividends. Both companies are expected to earn $6 per share in the coming year, but Company D (for dividends) is expected to pay out the entire amount one year from now as dividends, while Company G (for growth) is expected to pay out only one-third of its eanings or $2 per share. The companies are equally risky, and their required rate of return is 15 percent. D's constant growth rate is zero and G's is 8.33 percent. What are the expected prices of Stocks D and G?

Explanation / Answer

Required rate of return for both companies = 15%

For company D:

Dividend next year =$6

Growth rate =0

Intrinsic Value = 6 / (0.15 -0) = $40

For company G:

Dividend next year =$2

Growth rate =8.33%

Intrinsic Value = 2/ (0.15 - 0.0833) = $29.98

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