(Constant growth model) Medtrans is a profitable firm that is not paying a divid

Question

(Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A. G. Edwards, believes that Medtrans will begin paying a $1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James’ colleagues at the same firm, is less optimistic. Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%.

What value would James estimate for this firm?
What value would Bret assign to the Medtrans stock?

Explanation / Answer

Dividend paid is $1 for 2 years and then it would grow at 6% annually from the third
year, thus find the value of the firm at the end of second year.
P1 = D2/(r – g)

    = $1/(13% - 6%)

    = $14.29

To find out the present value of stock, discount the value of stock @13%
P0 = P1/(1 + r)1

     = 14.29/(1 + 0.13)1

     = $12.64

b)

Dividend paid is $1 for 4 years and then it would grow at 4% annually from the fifth
year, thus find the value of the firm at the end of fourth year.
P3 = D4/(r – g)

     = $1/(13% - 4%)

     = $11.11
To find out the present value of stock, discount the value of stock @13%
P0 = P1/(1 + r)3

    = 11.11/(1 + 0.13)3

    = $7.70

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