Question

Your company paid a dividend of $3.00 last year (DO =3.0). The growth rate is expected to be 10 percent for first year, 8 percent the second year, then 7 percent for the third year, and then the growth rate is expected to be a constant 6 percent thereafter. The required rate of return on equity (rs) is 10 percent. What is the company's current stock price (i.e., intrinsic value)? 0 $79.94 O $84.74 0 $73.32 O $67.47 $101.06

Answer 1

The company's current stock price is computed as shown below:

= Dividend at end of year 1 / ( 1 + required rate of return )¹ + Dividend at end of year 2 / ( 1 + required rate of return )² + Dividend at end of year 3 / ( 1 + required rate of return )³ + 1 / ( 1 + required rate of return )³ [ ( Dividend at end of year 3 ( 1 + growth rate ) / ( required rate of return - growth rate) ]

Dividend at end of year 1 is computed as follows:

= Dividend just paid x (1 + growth rate )

= $ 3 ( 1 + 0.10 )

= $ 3.30

Dividend at end of year 2 is computed as follows:

= Dividend at end of year 1 x ( 1 + growth rate )

= $ 3.30 x ( 1 + 0.08 )

= $ 3.564

Dividend at end of year 3 is computed as follows:

= Dividend at end of year 2 x ( 1 + growth rate )

= $ 3.564 x ( 1 + 0.07 )

= $ 3.81348

So the current stock price will be:

= $ 3.30 / 1.10 + $ 3.564 / 1.10² + $ 3.81348 / 1.10³ + 1 / 1.10³ [ $ 3.81348 ( 1 + 0.06 ) / ( 0.10 - 0.06 ) ]

= $ 3 + $ 2.945 + $ 2.865 + $ 75.926

= $ 84.74 Approximately

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