The stock of Plebane, Inc. currently sells for $15.00 per share. The company jus

Question

The stock of Plebane, Inc. currently sells for $15.00 per share. The company just paid a dividend of $2.10 per share and the current market price per share (i.e., $15.00) is based on investor belief that the dividends of the company will remain constant forever. Unknown to the market, however, is that Plebane is about to announce the introduction of a modified product line that will cause the future earnings and therefore dividends of the company to grow at a rate of 4 percent per year forever, starting today. This new growth rate will begin with the dividend to be paid one year from today. The modified product line will not in any way impact the required rate of return for the stock of Plebane, Incorporated. Assuming that the market reacts rationally, what will be the new stock price of Plebane, Incorporated after the announcement?

Explanation / Answer

Current price = Dividend / Required return 15=2.1/Required return Required return = 14% With dividend growth at 4% next dividend = 2.1(1.04) = 2.184 New Price = Dividend / (Required return - Growth rate) New Price = 2.184 ( 0.14-0.04) = $21.84

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