Jolly Juice Ltd. is expected to pay a $3.00 dividend next year and a $4 dividend in two years. After that, dividends are expected to grow at an annual rate of 5% forever. If investors require a return of 10% on the investment, what should jolly juice shares sell for today?
Step 1: Computation of market price at the end of year 2 using Gordon Growth Model
Using Gordon Growth Model
P2 = D3 / (Ke – g)
Where,
P2 - Market price at the end of year 2 = ?
D3 - Expected dividend in year 3 = D2*(1+g) = 4*1.05 = 4.20
Ke – Cost of equity = 10%
G – Growth rate in dividend = 5%
P2 = 4.2/(.10-.05)
= 4.2/.05
= $84.00
Step 2: Computing current share price by discounting the cashflow at required return
Year | Dividend | PVF@10% | Present Value (Cashflow*PVF) |
1 | 3 | 0.909 | 2.73 |
2 | 88 (4+84) | 0.826 | 72.73 |
Current share price = Cashflow*PVF
= 2.73+72.73
= $75.45
You can use the equation 1/(1+i)^n to find PVF using calculator
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