McPherson Enterprises is expected to pay a dividend (cash flow to investors) of

Question

McPherson Enterprises is expected to pay a dividend (cash flow to investors) of $2.25 per share at the end of the year (i.e. the dividend at t = l is expected to be $2.25). Investors also expect the company to pay the same dividend at the end of each of the following 2 years (at t = 2 and t-3) and will then increase the dividend to $3.00 for the subsequent 2 years (at t =4 and t-5). At 6 investors further expect that the dividend will increase and grow at a constant rate of 5 percent forever (hint: D6 = D5 x 1.05). The market further believes that the appropriate discount rate for these expected future cash flows (the required return on the company's common stock) is 11 percent per year. Estimate the current market price for a share of stock O A. $52.50 D. $50.00 O B. $40.41 e C. $37.50

Explanation / Answer

D1,2,3 = 2.25

D4,5 = 3

g = 5%

Re = 11%

Terminal value = 3*(1+5%) / (11% - 5%) = 52.5

Price = 2.25 / (1+11%) + 2.25 / (1+11%)2 + 2.25 / (1+11%)3 + 3/ (1+11%)4 + (3 + 52.5) / (1+11%)5

= 40.41  (Option C)

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