Assume that the average firm in your company\'s industry is expected to grow at
ID: 2637943 • Letter: A
Question
Assume that the average firm in your company's industry is expected to grow at a constant rate of 6% and that its dividend yield is 8%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work that leads you to expect that its earnings and dividends will grow at a rate of 50% [D1 = D0(1 + g) = D0(1.50)] this year and 30% the following year, after which growth should return to the 6% industry average. If the last dividend paid (D0) was $1.25, what is the value per share of your firm's stock? Round your answer to the nearest cent. Do not round your intermediate computations.
Explanation / Answer
To calculate the value of stock, we will have to calculate the present value of dividends upto year 2 and the price at the end of year 2. The formula for calculating the total present value will be:
Present Value (Stock Price) = D1/(1+Required Return)^1 + D2/(1+Required Return)^2 + D2*(1+Growth Rate)/(Required Return - Growth Rate)*(1+Required Return)^2
Where last part of the equation represents the present value of price at the end of year 2.
________
Required Return = Dividend Yield + Average Constant Growth Rate
____________
Solution:
Required Return = 5% + 4% = 9%
D1 = 2.25*(1+50%)
D2 = 2.25*(1+50%)*(1+30%)
P2 = 2.25*(1+50%)*(1+30%)*(1+4%)/(9% - 4%)
Using these values in the above formula, we get,
Present Value (Stock Price) = 2.25*(1+50%)/(1+9%)^1 + 2.25*(1+50%)*(1+30%)/(1+9%)^2 + 2.25*(1+50%)*(1+30%)*(1+4%)/(9% - 4%)(1+9%)^2 = $83.60 or $83.6 (answer)