Metallica Bearings, Inc., is a young start-up company. No dividends will be paid
ID: 2775967 • Letter: M
Question
Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next ten years, because the firm needs to plow back its earnings to fuel growth. The company will then pay a $12.30 per share dividend in year 11 and will increase the dividend by 5.25 percent per year thereafter.
If the required return on this stock is 12.75 percent, what is the current share price?
Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next ten years, because the firm needs to plow back its earnings to fuel growth. The company will then pay a $12.30 per share dividend in year 11 and will increase the dividend by 5.25 percent per year thereafter.
Explanation / Answer
The formula according to dividend growth model is
Ke = D11/P10 + g
where Ke =12.75% =0.1275
D11 = Dividend in 11th year= $12.30
P10 = ?
g=5.25% = 0.0525
Now, substituting in the formula
0.1275 = 12.30/P10 + 0.0525
P10 = 164
So price in the 10th year is 164
Hence current price will be 164/1.1275^10 = 49.39
Hence current price is $49.39