One of your colleagues has recommended that you buy 10 shares in a certain company, say, ABC Ltd. He tells you that the company has a good track record of paying regular dividend every year and the dividends are likely to grow at a rate of 4% per year on an average for the foreseeable future. The next dividend is expected to be $1.50 per share and the shares are selling in the secondary market for $28.50 per share. As per your financial plans and life profile, you feel that any risky investment like in shares of a company, should earn at least 9% per annum. 1. Compute the intrinsic value of the share (Intrinsic value of any financial instrument is the value that it should sell for in the market). 2. Will you buy these shares? give reason with relevant computations. 3. What might cause a difference between a share’s intrinsic value and its market price?
One of your colleagues has recommended that you buy 10 shares in a certain company, say, ABC Ltd. He tells you that the company has a good track record of paying regular dividend every year and the dividends are likely to grow at a rate of 4% per year on an average for the foreseeable future. The next dividend is expected to be $1.50 per share and the shares are selling in the secondary market for $28.50 per share.
As per your financial plans and life profile, you feel that any risky investment like in shares of a company, should earn at least 9% per annum.
1. Compute the intrinsic value of the share (Intrinsic value of any financial instrument is the value that it should sell for in the market).
2. Will you buy these shares? give reason with relevant computations.
3. What might cause a difference between a share’s intrinsic value and its market price?
The value of any financial asset = present value of its future cashflows.
And dividend discount model assumes that the intrinsic value of a share = present value of its future dividends, which is given by
IV = D1/(K - g)
Where
D1 = dividend expected next year = $1.50
K = cost of capital = 9%
g = growth rate of dividend = 4%
Therefore,
IV = 1.5/(.09 - .04) = $30 this is the price at which the share should be traded in the market.
Step by step
Solved in 3 steps
