Question

Sallie Mae Clothing is in the process of selling its peripheral businesses and returning to a pure clothing store. In conjunction with this reorganization, the dividend will be decreased by 20 percent in each of the next 2 years. After that, the dividend will resume its historical pattern of 3 percent annual increases. The required return on this stock is 10 percent and the last dividend paid was $3 a share. What is one share of this stock worth today? Please show all work and explain the individual steps taken to get the answer. Thank you.

Answer 1

Step-1, Dividend for the next 2 years

Dividend in Year 1 (D1) = $2.40 per share [$3.00 x 80%]

Dividend in Year 2 (D2) = $1.92 per share [$2.40 x 80%]

Step-2, The Price of the stock in year 2 (P2)

Dividend Growth Rate after 2 years (g) = 3% per year

Required Rate of Return (Ke) = 10%

Therefore, the Share Price in year 2(P2) = D2(1 + g) / (Ke – g)

= $1.92(1 + 0.03) / (0.10 – 0.03)

= $1.9776 / 0.07

= $28.25 per share

Step-3, Current Price per share

As per Dividend Discount Model, The Current Price per share is the aggregate of the Present Value of the future dividend payments and the present value the share price in year 2

Year	Cash flow ($)	Present Value factor at 10%	Present Value of cash flows ($)
1	2.40	0.90909	2.18
2	1.92	0.82645	1.59
2	28.25	0.82645	23.35
TOTAL			27.12

“Therefore, the today’s worth of one share of this stock will be $27.12 per share”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.