Quiz 11 Faddy Corporation\'s only line of business is to produce special birthda

Question

Quiz 11 Faddy Corporation's only line of business is to produce special birthday cakes for customers with birthdays on February 29th, Therefore Faddy only pays dividends in leap years. The next dividend of $6 per share will be paid in four years, and subsequent dividends will grow by 10% per four-year period. That is, in 8 years the dividend will be $6.60, in 12 years the dividend will be $7.26, and so on. Suppose the discount rate for Faddy is 7% per year (simple annual rate). Calculate the fundamental or intrinsic value of a share of Faddy stock

Explanation / Answer

As the dividend is paid only every four years the effective rate of discount for 4 years using annual compounding is to be used. The effective rate of discount for 4 years = 1.07^4-1 = 31.08% The valuation is to be done using the constant dividend growth formula of D1/(r-g) where D1 = the next expected dividend (4 years after) r = required rate of return = 31.08% g = growth rate = 10% every four years. Substituting values, intrinsic value of a share of Faddy stock = 6/(0.3108-0.10) = $            28.46

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