A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The d

Question

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT?

a. The company's current stock price is $20. b. The company's expected stock price at the beginning of next year is $9.50. c. The constant growth model cannot be used because the growth rate is negative. d. The company's expected capital gains yield is 5%. e. The company's dividend yield 5 years from now is expected to be 10%.

Explanation / Answer

Expected dividend,D1 = $2

Growth rate,g = -5%

Required rate of return,RR = 15%

D2 = D1*(1 + g) = $2*(1 - 5%) = $1.90

Current price of stock,P0 = D1 / (RR - g)

= $2 / (15% - (-5%))

= $2 / 20%

= $10

Price of stock at beginning of next year,P1 = D2 / (RR -g)

= $1.9/(15%+5%)

= $9.5

Ans : b

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