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Stock Valuation and Future Dividends Response

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Give a response to the statement:

"You say stock price equals the present value of future dividends? That's crazy! All the investors I know are looking for capital gains."

This statement takes into consideration the fact that people invest in shares of stock for different reasons. Some people invest long-term for the constant dividends that are paid at regular intervals. Other people are looking to buy shares and sell them in the short-term, on the up-tick, to acquire capital gains. These differences in investment strategy may influence a person's perception on the stock price as being either high or low, making it more or less attractive.

However, I think it is important to note that the stock price does equal the present value of future dividends. Even if you wanted to contribute some portion of the price to future earnings, one must realize that this portion of the price is going to be the same amongst stocks in comparable risk classes. Therefore, it is my interpretation that you can simply dismiss this when determining the present value and focus primarily on dividends.

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I do not agree with this statement. In my opinion, the stock price is based on expectations about future cash flows of the ...

Solution Summary

This solution discusses how today's stock prices are not based on present value of future dividends, and also presents the factors that affect the stock prices.

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Stock Valuations

I am having all kinds of trouble with stock valuations. I have read my chapter material twice, but cannot figure the attached problems. Also, if this is calculated in excel, how to calculate?

1.

General Cereal common stock dividends have been growing at an annual rate of 7 percent per year over the past 10 years. Current dividend (D o) is 1.70 per share. What is the current value of a share of this stock to an investor who requires a 12 percent rate of return if the following conditions exist?

a. Dividends are expected to continue growing at the historic rate for the foreseeable future.
b. The dividend growth rate is expected to increase to 9 percent per year.
c. The dividend growth rate is expected to decrease to 6.5 percent per year.

2.

The Foreman Company's earnings and common stock dividends have been growing at an annual rate of 6 percent over the past 10 years and are expected to continue growing at this rate for the foreseeable future. The firm currently (D o) pays an annual dividend of $5 per share. Determine the current value of a share of Foreman common stock to investors with each of the following required rates of return:

a. 12 percent
b. 14 percent
c. 16 percent
d. 6 percent
e. 4 percent

3.

Over the past 5 years, the dividends of the Gamma Corporation have grown from $0.70 per share to the current level of $1.30 per share (D o). This growth rate is expected to continue for the foreseeable future. What is the value of a share of Gamma Corporation common stock to an investor who requires a 20 percent return on an investment?

4.

The chairman of Hellerman Industries told a meeting of financial analysts that he expects the firm's earnings and dividends to double over the next 6 years. The firm's current (that is, as of year 0) earnings and dividends per share are $4 and $2, respectively.

a. Estimate the compound annual dividend growth rate over the 6-year period.
b. Assuming the forecasted growth rate in (a) will go on forever, how much is this stock worth today if investors require an 18 percent rate of return?
c. Why might the stock price calculated in (b) not represent an accurate valuation to an investor with 18 percent required of return?

11.

The Kummins Engine Company common stock has a beta of 0.9. The current risk-free rate of return is 5 percent and the market risk premium is 8 percent. The CEO of the company is quoted in a press release as saying that the firm will pay a dividend $0.80/share in the coming year and expects the dividends to grow at a constant rate of 7 percent for the foreseeable future. Using the constant growth model, what value would you assign to this stock?

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