Nonconstant Growth Stock Valuation Assume that the average firm in your company\
ID: 2813476 • Letter: N
Question
Nonconstant Growth Stock Valuation
Assume that the average firm in your company's industry is expected to grow at a constant rate of 4% and that its dividend yield is 6%. Your company is about as risky as the average firm in the industry and just paid a dividend (D0) of $2.25. You expect that the growth rate of dividends will be 50% during the first year (g0,1 = 50%) and 25% during the second year (g1,2 = 25%). After Year 2, dividend growth will be constant at 4%. What is the required rate of return on your company’s stock? What is the estimated value per share of your firm’s stock? Do not round intermediate calculations. Round the monetary value to the nearest cent and percentage value to the nearest whole number.
Explanation / Answer
1. Required rate of return as according to Dividend discount approach = Dividend yield + growth rate of Dividends = 6% +4% = 10%. Since the firm is as risky as any firm in the industry, investors would expect same rate of return as growth rate.
2. Value of stock can be determined by the following steps -
a. Calculate the Present value of dividends in high growth periods, discounted at required rate of return of 10%.
End of Year 1: Dividend= $2.25*(1+50%)= $3.375. PV of Dividend= 3.375/(1+10%)= 3.375/1.1= $3.068
End of Year 2: Dividend=$3.375*(1+25%)=$4.220. PV of Dividend= 4.220/(1+10%)^2= 4.220/1.21= $3.487
Total PV of Dividends in high growth periods = 3.068+3.487= $6.55
b. Calculate present value of Stock based on period of steady growth discounting the value to t=0
Dividend at Year 3= $4.22*(1+4%)= $4.38
Value of stock at stable growth rate= Dividend/(Rate of return-Dividend growth rate) = 4.38/(10%-4%)= $73
PV of Stock at start of Year 1 = $73/(1+10%)^2=73/1.21= $60.33
c. Add the totals of steps a & b.
Estimated Value of firm's stock = $6.55 +$60.33 = $66.88
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.