An investor with a required return of 14 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase. The information is as follows: Firm
Firm A B C
Current Earnings $2.00 $3.20 $7.00
Current dividend $1.00 $3.00 $7.50
Expected annual growth in
dividends and earnings 7% 2% -1%
Current market price $23 $47 $60
(a) What is the maximum price that the investor should pay for each stock based on the dividend-growth model?
(b) If the investor does buy stock A, what is the implied percentage return?
(c) If the appropriate P/E ratio is 12, what is the maximum price the investor should pay for each stock? Would your answers be different if the appropriate P/Ewere 7?
(d) What does stock C's negative growth rate imply?
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