4. A company just paid an annual dividend of $3 per share on its common stock. D

Question

4. A company just paid an annual dividend of $3 per share on its common stock. Due to the success of a new product, the firm expects to achieve a dramatic increase in its short-term growth rate in sales to 30 percent annually for the next three years. After this time, the growth rate in sales is expected to return to the long-term constant rate of 5 percent per year. Assume that the company's dividend growth rate matches the rate of growth in sales. If the required return on the stock is 16 percent per year, what is the current stock price? Assume that dividends are paid annually

Explanation / Answer

According to dividend discount model, Current Price of stock is the present value of future dividends from stock. Step-1:Calculation of present value of dividend of next 3 years Year Dividend Discount factor @16% Present Value 1 $       3.90                         0.862 $                 3.36 2 $       5.07                         0.743 $                 3.77 3 $       6.59                         0.641 $                 4.22 Total $               11.35 Step-2:Calculation of terminal value Terminal Value of dividend = D3*(1+g)/(Ke-g) Where, = 6.59*(1+0.05)/(0.16-0.05) D3 Dividend of Year 3 $       6.59 = $                 62.90 Ke Required return 16% g Growth rate 5% Step-3:Calculation of present value of terminal value Present value of terminal value = Terminal Value x Discount factor for Year 3 = $                 62.90 x         0.641 = $                 40.30 Step-4:Calculation of present value of total dividend Present value of all dividend = Present Value of 3 years dividend + Present value of terminal value of dividend = $                 11.35 + $    40.30 = $                 51.65 So, Current Value of stock is $ 51.65

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