CFA Practice Question

There are 96 practice questions for this study session.

CFA Practice Question

An investor plans to invest in a stock, but has not decided yet whether his investment will have one-, two-, or three-period horizon. The company's stock is currently trading at $27.5 and current dividend is $3. His forecast of dividend and stock price (at the end of each year) is given as below:

Provided that the required rate of return on the stock is 10%, which investment horizons will make its stock attractive for the investor?
A. Three year
B. Two year
C. One year
Explanation: One-period DDM: V0 = D1 / (1 + r) + P1 / (1 + r) = 2 / (1 + 0.1) + 24 / (1 + 0.1) = $23.6.

Two-period DDM: V0 = D1 / (1 + r) + D2 / (1 + r)2 + P2 / (1 + r)2 = 2 / (1 + 0.1) + 2.5 / (1 + 0.1)2 + 28 / (1 + 0.1)2 = $27.0.

Three-period DDM: V0 = D1 / (1 + r) + D2 / (1 + r)2 + D3 / (1 + r)3 + P3 / (1 + r)3 = 2 / (1 + 0.1) + 2.5 / (1 + 0.1)2 + 3.0 / (1 + 0.1)3 + 30 / (1 + 0.1)3= $28.7.

Depending on the investor's investment horizon, the stock value will be $23.6, $27.0, or $28.7. Since the stock is currently trading at $27.5, the stock is attractive only in the three-year period. Although the company will trade higher than its current price in two years' time, the price appreciation is not enough to compensate the investor for the time value of money.

User Contributed Comments 4

User Comment
Rotigga Return(1) = (D + P1)/P0 - 1 = (2 + 24)/27.5 - 1 = -5%
Return(2) = (4.5 + 28)/27.5 - 1 = 18.18%
Annualized return = (1+0.1818)^0.5 = 8.7% EAR
Return(3) = (7.5 + 30)/27.5 - 1 = 36.36%
Annualized return = (1.3636)^(1/3) = 10.89% EAR
tim2 So what's up with the "current dividend is 3"? I guess just forget it? Maybe it's gone ex-div and the question can't be bothered saying so?
hks101 Rotigga, if the current price is $29, then all three investment horizons will not be considered attractive.

tim: yes it should be ignored. You want to use the future dividend.
darbyland tim2 - i got confused as well and ended up plugging in 3 into the formula without discounting it. i guess its good to remind ourselves about multi-holding period V0 formula where it starts with D1
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