You would like to buy a share of XYZ Company common stock. Dividend information

Question

You would like to buy a share of XYZ Company common stock. Dividend information on the company is as follows: XYZ declared a .50 cents per share dividend today. They anticipate extraordinary growth in the next 3 years. Dividends are expected to grow by 50%, 60% and 25% respectively in the next 3 years. After this period, dividends are expected to grow at constant rate of 6% forever. The required rate of return on this stock is 10%.

1. Draw a cash flow timeline for the dividends

2. Complete the following statement: The value of an asset is ________________

3. What would consider a fair price for the stock today?

Explanation / Answer

1. Cash flow timeline for dividends:

2. The value of an asset is the present value of its future cash flows.

3. The fair value of the stock is the present value of its dividends. It will be calculated in 2 parts: dividends for the year 0, 1, 2, 3+dividends from the 4th year onwards.

Calculation of present value of dividends paid during the year 0 to year 3: (formula used: PV = amount/(1+rate of return)^time

Now, we will calculate the value of dividends growing at a constant rate of 6%. formula = dividend amount/return rate - growth rate

dividend amount in year 3 = 1.5 cents.

so, value of stock = 1.5/10% - 6% = 1.5/4% = 37.5 cents. This is the value at the end of 3rd year.

Now we have to calculate the PV of 37.5 cents. PV = 37.5/(1.1^3) = 37.5/1.331 = 28.2 cents

Fair price of the stock = sum of the PVs as calculated above = 3.3 cents+28.2 cents = 31.5 cents

Year Initial dividend Growth Dividend (formula) Dividend amount 0 0.5 1 50% 1.5*0.5 0.75 2 60% 1.6*0.75 1.2 3 25% 1.25*1.2 1.5

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