CFA CFA Level 1 Question help: Valuing share price based on future dividend payments

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Question help: Valuing share price based on future dividend payments

Topic Resolution: Resolved
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    • pd25
      Participant
        • CFA Level 1
        Up
        6
        ::

        Bill Bailey and Sons pays no dividend at the present time. The company plans to start paying an annual dividend in the amount of $.30 a share for two years commencing two years from today. After that time, the company plans on paying a constant $1 a share dividend indefinitely. How much are you willing to pay to buy a share of this stock if your required return is 14 percent?

        A: $4.82

        B: $5.25

        C: $5.39

        D: $5.46

        E: $5.58

         

        The right answer is B. I have understood the question but not able to get the right answer.

        Sophie Macon voted upNeil Harkness voted up
      • shanky
        Participant
          • CFA Level 2
          Up
          4
          ::

          Isn’t the calculation in the present value of $1 annuity incorrectly written, I got 4.23 everytime i tried?

          • Up
            1
            ::

            Got a bit carried away compressing my steps and had a typo – it should be 1.143, not 1.144.

            After the second payment, 3 years from now, the ‘present’ value of the $1 perpetuity payments is 1/0.14. So calculating the present value to year 0 would be:

            ( 1 / 0.14 ) / 1.143

            = 4.82

            Sorry! 😜

            shanky voted up
        • Up
          3
          Accepted answer
          ::

          To calculate this, sum up the present value (PV) of three components:

          • $0.30 payment 2 years from now
          • $0.30 payment 3 years from now
          • $1 annual payment to perpetuity 4 years from now

          Present value of a payment to perpetuity is

          PV = C / R

          Where:

          PV = Present value
          C = Amount of continuous cash payment ($1 in your example)
          r = Interest rate or yield (14% in your example)

          Calculations:

          • $0.30 payment 2 years from now = $0.30 / 1.142 = $0.23
          • $0.30 payment 3 years from now = $0.30 / 1.143 = $0.20
          • $1 annual payment to perpetuity 4 years from now = ( $1 / 0.14 ) / 1.144 = $4.82

          Adding them all up get you the total PV

          = $0.23 + $0.20 + $4.82

          = $5.25

          Sophie Macon voted uppd25 voted up
          • pd25
            Participant
              • CFA Level 1
              Up
              0
              ::

              Thank you so much! I got it partially correct and now I see where I made the mistake. 🙂

          • Up
            0
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            No problem. If you have any further questions just create a new topic!

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