Management has recently announced that expected dividends for the next three yea

Question

Management has recently announced that expected dividends for the next three years will be as follows:

Year    Dividend

   1        $3.50

   2          2.75

   3          2.00

The firm's assets will then be liquidated and the proceeds invested in the preferred stock of other firms so that the company will be able to pay an annual dividend of $1.75 indefinitely. If your required return on investments in common stock is 10 percent, what is the maximum you should pay for this stock? Round your answer to the nearest cent.

Explanation / Answer

Value Of Stock = Present Value of all the dividends to be received for lifetime

= D1 / (1+r) + D2 /(1+r)^2 + D3/ (1+r)^3 + Present Value of D4 /(r)

D4/r is the terminal value since we will receive the dividend of 1.75 every year till perpetuity and present value of perpetuity is given by Cash Flow/Discount Rate. SInce the present value of perpetuity is at year 3 we need to discount it back to today for additional 3 years

So Value Of Stock = 3.5/(1.1) + 2.75 /(1.1)^2 + 2/(1.1)^3 + (1.75/0.10)/(1.1)^3

= 3.18 + 2.27 + 1.50 + 13.15 = $ 20.10

Hence the fundamental price of stock is $20.10

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