Chartered Financial Analyst (CFA) Practice Exam Level 2

How is the Future Price (F0) of a stock calculated when considering dividends?

1. F0 = S0 * (1 + Rf)^T + FVD

2. F0 = S0 - PVD + (1 + Rf)^T

3. F0 = S0 * (1 + Rf)^T - FVD

4. F0 = (S0 - PVD) * (1 + Rf)^T

The correct answer is: F0 = S0 * (1 + Rf)^T - FVD

The formula for calculating the future price (F0) of a stock when considering dividends takes into account the current price of the stock, the risk-free rate, and any dividends that will be paid before the future price is realized. In this case, the correct formula expresses that the future price is derived from the current stock price compounded by the risk-free rate over a certain time period, while also adjusting for the present value of dividends (FVD). Specifically, it calculates the future price as the current stock price multiplied by the factor (1 + Rf)^T, which captures the effect of compounding at the risk-free rate. The adjustment for the present value of dividends means that these dividends, which reduce the value of the stock when they are paid out, are taken into consideration. This understanding is crucial because dividends are typically paid out and thus reduce the future value of the stock from the perspective of the investor. Therefore, the future price must account for this reduction in value. By incorporating the future value of dividends appropriately, the calculation ensures that the expected future price accurately reflects both the growth attributable to investing at the risk-free rate and the reduction in value due to dividend payouts. The other choices incorporate various incorrect dynamics in how they treat the stock