Fin-534 homework set number 3
The most you should pay for the stock if you plan to buy it, hold it for three years, and then sell it for $27.05 is its intrinsic value or the present value of all expected future cash flows. To calculate this figure, you need to take into account factors such as current market price, interest rates, dividends/earnings per share etc.
For example, let’s say a particular stock is currently trading at $20 and has a dividend yield of 4% per annum while inflation rate is 2%. This means that after accounting for inflation the real return from holding the stock would be 2%. By using discounted cash flow (DCF) analysis we can determine how much this expected return translates into in terms of present-day value i.e. how much we should be willing to pay for the stock today in order to yield an annualized return of 2% for 3 years.
In this case assuming a discount rate of 8%, then our DCF calculation would suggest that we should not pay more than $22.94 ($20 + 3 x 0.04 x 1.02^3) which represents an intrinsic value slightly higher than the intended selling price after 3 years so that we can benefit from capital gains as well as income derived from dividends during our holding period.