Assume that the average firm in your company\'s industry is expected to grow at
ID: 2616436 • Letter: A
Question
Assume that the average firm in your company's industry is expected to grow at a constant rate of 5% and that its dividend yield is 8%. Your company is about as risky as the average firm in the industry and just paid a dividend (D0) of $1. You expect that the growth rate of dividends will be 50% during the first year (g0,1 = 50%) and 20% during the second year (g1,2 = 20%). After Year 2, dividend growth will be constant at 5%. What is the estimated value per share of your firm’s stock? Do not round intermediate calculations. Round your answer to the nearest cent.
Explanation / Answer
Step 1: Computation of market price at the end of year 2 using Gordon Growth Mdel
P2 = D3 / (Ke-g)
Where
P2 - Market Price at the end of year 2
D3 - Expected dividend in year 3
Ke - rate of return
g - growth rate
P2 = D3 / (Ke-g)
= (1*1.5*1.2*1.05) / (.08 - .05)
= 1.89 / .03
= $63
Step 2: Computing current share price by discounting the cashflow at dividend yield
current share price = $56.92 (1.389+55.5336)
*PVF = 1/1.08 = .926
**PVF = 1/1.082 = .857
Year Dividend PVF@8% Present Value (Cashflow*PVF) 1 1.5 0.926* 1.389 2 64.8 (1.8+63) 0.857** 55.5336