The common stock of Peachtree Paper, Inc., is currently selling for $40 a share.

Question

The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant rate of 10%.

(a)Using the variable growth DVM model. If the dividends are expected to have a growth rate of 10% in the future 3 years, and 8% in the following 2 years and remain constant at 5% from year 6, assuming 10% required return, what is the intrinsic value of the share? Is this a good investment if the share is bought at the current market price?

Explanation / Answer

Answer: Calculation of intrinsic value per share:

Dividend in next year=Dividend in Previous year(1+growth rate)

D0=$2.00

D1=$2.00(1.10)=2.2

D2=2.2(1.10)=2.42

D3=2.42(1.10)=2.662

D4=2.662(1.08)=2.87496

D5=2.87496(1.08)=3.10495

D6=3.10495*(1.05)=3.260

P5=D6/(required return-Growth rate)

=3.260/(0.10-0.05)=$65.2

If intrinsic value > market price undervalued: Good Investment

50.38>$40: Good investment

Year Dividend Price Total cash flow P.V.F (10%) PV ($) 1 2.2 2.2 0.909090909 2.00 2 2.42 2.42 0.826446281 2.00 3 2.662 2.662 0.751314801 2.00 4 2.87496 2.87496 0.683013455 1.96 5 3.104957 65.2 68.3049568 0.620921323 42.41 Intrinsic value 50.38

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