Simpkins Corporation does not pay any dividends because it is expanding rapidly
ID: 2762439 • Letter: S
Question
Simpkins Corporation does not pay any dividends because it is expanding rapidly and needs to retain all of its earnings. However, investors expect Simpkins to begin paying dividends, with the first dividend of $1.00 coming 3 years from today. The dividend should grow rapidly - at a rate of 70% per year - during Years 4 and 5. After Year 5, the company should grow at a constant rate of 8% per year. If the required return on the stock is 18%, what is the value of the stock today (assume the market is in equilibrium with the required return equal to the expected return)? Round your answer to the nearest cent. Do not round your intermediate computations.
Explanation / Answer
Answer:
The Current Market Price of Simpkins Corporation’s Share is the sum of following:
1) Present Value of expected dividend from 1 to 5 Years and
2) Present Value as on today of the Share Market Price at the end of Year 5 calculated by using constant dividend growth model
Present Value of expected dividend from 1 to 5 Years
Year
Dividend Amount
PV Factor @ 18%
Present Value
D1
0
0.847
0.00
D2
0
0.718
0.00
D3
$1
0.609
0.61
D4
$1 x (1+0.7) = $1.70
0.516
0.88
D5
$1.7 x 1.7 = $2.89
0.437
1.26
2.75
Market Price of Share at the end of Year 5 = D6 / (Required Return – Growth Rate)
= ($2.89 x 1.08) / (0.18 – 0.08)
= $3.1212 / 0.10
= $31.212
Present Value of $31.212 as on today = $31.212 x 0.437 = $13.64
Hence, the Current Market Price of Share = $2.75 + $13.64 = $16.39 or $16.40
Year
Dividend Amount
PV Factor @ 18%
Present Value
D1
0
0.847
0.00
D2
0
0.718
0.00
D3
$1
0.609
0.61
D4
$1 x (1+0.7) = $1.70
0.516
0.88
D5
$1.7 x 1.7 = $2.89
0.437
1.26
2.75
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