Question

" You expect Caterpillar will pay dividends of 1.75 in one year, 2.00 in two years, and 2.50 in three years. From that point onwards, dividends will grow at 4% per year. Investors' required rate of return is 10%. According to the Dividend Discount Model, what should be Caterpillar's stock price?"

Answer 1

First we have to calculate the present value of the stock price for three years.

Next, we have to add the present value of the dividends that are they will pay between today and that date, therefore, within three years the price will be:

D3(1g 1.04 2.6 P3 0.10-0.040 24.3333

where R=10%. g=4% D₃=dividend 3

Then, we can calculate the total value of the shares as the present value of the first three dividends, plus the present value of the price at time 3, P3:

D2 D3 P3 Di

Po = (1.101 + (1.10), (1.10) (1.10)3

Po = 1.59 1.65 1.87 18.28 = 23.39

therefore 23.39 is the price of the shares.