A schweser question asks:
“An analyst estimates that a stock will pay a $2 dividend next year and that it will sell for $40 at year-end. If the required rate of return is 15%, what is the value of the stock?”
I thought this meant that next year a 2 dollar dividend is paid, and at the end of this year it is sold for $40. That’s not the case. What am I missing in the grammatical structure of this sentence so I don’t run into this problem on the exam?
I don’t care for this question because I would not place any weight on an analyst’s target price but here is how I would answer the question, assuming I believed the analyst. Total cash flow next year if you buy the stock should be $42 ($40 stock price plus $2 in dividends). The discount factor for 1 year at 15% is 0.8696 which was calculated as 1/(1+.15), Multiplying the discount factor and the $42 of cash results in a net present value of $36.52. This assumes the analyst’s estimate of $40 is ex-dividend.
Thanks for the reply, but what I’m stuck on the wording of this question. “it will sell for $40 at year end” seems kind of confusing. Couldn’t that mean any year end?
I think the key words here are “estimates,” “will pay,” “next year,” and “will sell.” All these words imply the future. Having said that, this is a typical calculator question. Don’t bother trying to solve it by hand. With BAII Plus, enter cashflows: CF0=0, CF1=40+2 Then press NPV I=15, NPV = CPT (compute) Answer is $36.52
The analyst is judging the value of the stock based upon his idea of what amount the stock will trade and according to that calculating the value at the present time.
We should be able to vote on this question.