Question

1. LED, Inc. just paid a dividend of $2.50 per share. The dividends are expected to grow for the next 3 years at 8% per year, then grow at 3% per year forever. The required rate of return for LED stock is 12% per year.

1. What should the market price of LED stock be?
2. What should the ex-dividend stock price of LED be in year 2?
3. If you purchased the share of LED at time 2, at the price you calculated in b), and held it for one year, what should the return on investing in LED stock be? What portion of that return comes from dividends, and what portion from capital gain?
4. What is the ex-dividend stock price of LED at time 3? What does this value represent?

Answer 1

Year	Working	Growth Rate	Dividend	Discounting Factor @ 12%	Present Value
0			2.50000
1	2.5*1.08	8%	2.70000	0.892857143	2.41
2	2.70*1.08	8%	2.91600	0.797193878	2.32
3	2.916*1.08	8%	3.14928	0.711780248	2.24
					6.98
4	3.14928*1.03	3%	3.24376

Terminal Value at the end of 3^rd year = D4/(Re-g)

= 3.24376/(0.12-0.03)

= 3.24376/0.09

= $36.04176

.

.

Present Value of above = 36.04176/1.12^3

= $25.65

.

.

Part-a:

Market price of the LED stock = 6.98 + 25.65

= $32.63

.

Part-b:

Year	Working	Growth Rate	Dividend	Discounting Factor @ 12%	Present Value
0	2.5*1.08	8%	2.70000
1	2.70*1.08	8%	2.91600	0.892857143	2.60
2	2.916*1.08	8%	3.14928	0.797193878	2.51
					5.11
3	3.14928*1.03	3%	3.24376

.

The ex-dividend stock price of LED be in year 2 = 5.11 + 25.65

= $30.76

.

.

Part-c:

Return that comes from dividend = 2.916/30.76 * 100

= 9.48%

.

.

Part-d:

Value at the end of 3^rd year = D4/(Re-g)

= 3.24376/(0.12-0.03)

= 3.24376/0.09

= $36.04176

.