Question

The ABC Value Company paid a dividend last week of $2/share. Their dividend for next year is expected to be 100% higher, and 50% higher for the following year. In the third year and each year thereafter, the dividend is expected to grow by 6%. If your client has a required rate of return of 10%, what is the most that they would pay to own ABC Value Co?

Answer 1

The price is computed as shown below:

= Dividend in year 1 / ( 1 + required rate of return )¹ + Dividend in year 2 / ( 1 + required rate of return )² + 1 / ( 1 + required rate of return )² x [ ( Dividend in year 2 ( 1 + growth rate ) / ( required rate of return - growth rate ) ]

Dividend in year 1 is computed as follows:

= Current dividend + 100%

= $ 2 + $ 2 x 100%

= $ 4

Dividend in year 2 is computed as follows:

= Dividend in year 1 + 50% of dividend in year 1

= $ 4 + $ 4 x 50%

= $ 6

So the price of the stock will be:

= $ 4 / 1.10 + $ 6 / 1.10² + 1 / 1.10² x [ ( $ 6 x 1.06 ) / ( 0.10 - 0.06 ) ]

= $ 140

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