The Eastern Company has an expected dividend of S1.25 per share in year 1, follo
ID: 2819206 • Letter: T
Question
The Eastern Company has an expected dividend of S1.25 per share in year 1, followed by a $1.5625 per share dividend in year 2, and S1.953 per share in year 3 with a growth of 5% per year thereafter. The appropriate market capitalization rate is 20% per year 1. What is the intrinsic value of a share of the stock? 2. Assuming current market price of a share is equal to its intrinsic value. Calculate the expected dividend yield (total value of dividends that an investor expects to receive from holding a dividend-yielding stocks). 3. What do you expect its price to be 1 year from now? Is the implied capital gain consistent with your estimate of the dividend yield and the market capitalization rate (expected return on a security)Explanation / Answer
1)
Present value at year 2 = D3 / k - g
Present value at year 2 = 1.953 / 0.2 - 0.05
Present value at year 2 = 13.02
Present value = 13.02 / ( 1 + 0.2)2
Present value = 9.042
Present value of year 1 dividend = 1.25 / ( 1 + 0.2)
Present value of year 1 dividend = 1.042
Present value of year 2 dividend = 1.5625 / ( 1 + 0.2)2
Present value of year 2 dividend = 1.085
Intrinsic value of share = 1.085 + 1.042 + 9.042
Intrinsic value of share = $11.17
2)
Dividend yield = D1 / current share price
Dividend yield = 1.25 / 11.17
Dividend yield = 0.1119 or 11.19%
3)
Price of year 1 = ( price of year 2 + dividend of year 2) / ( 1 + r)
Price of year 1 = ( 13.02 + 1.5625) / ( 1 + 0.2)
Price of year 1 = $12.152
capital gain = ( 12.152 - 11.17) / 11.17
capital gain = 0.0879 or 8.79%
The sum of the implied capital gains yield and the expected dividend yield is equal to the market capitalization rate. This is consistent with the DDM.