XYZ Pharmaceutical, Inc. just got FDA approval for their new drug, Viagrina. The

Question

XYZ Pharmaceutical, Inc. just got FDA approval for their new drug, Viagrina. The company has never paid a dividend, but they expect to pay one for the first time by the end of the year. The expected dividend is $3.00 per share and the company expects that dividend to increase at a rate of 20% for five years. After that, XYZ expects to see its dividend growth limited by the growth rate the US economy, which on average is 4.5% per year. If the required rate of return for other startup pharmaceutical companies like XYZ is 11%, what should be the fair price of XYZ’s stock today?

Explanation / Answer

XYZ's stock price would be composed of two parts. The first part will be the summed present value of the supernormally growing dividends at 20 % per annum for five years. The second part will be the present value of the terminal value of the perpetually growing dividends beginning from the end of year 6.

Year 1 Dividend = D1 = $ 3

D2 = D1 x 1.2 = $ 3.6, D3 = D2 x 1.2 = $ 4.32, D4 = D3 x 1.2 = $ 5.184, D5 = D4 x 1.2 = $ 6.2208 and D6 = 6.2208 x 1.045 = $ 6.500736

Discount Rate = 11 %

Terminal Value of Perpetual Dividends at end of Year 5 = 6.500736 / (0.11 - 0.045) = $ 100.011

PV of TV of Perpetual Dividends at present = P1 = 100.011 / (1.11)^(5) = $ 59.35

Present Value of supernormally growing dividends = P2 = 3 /1.1 + 3.6 / (1.1)^(2) + 4.32 / (1.1)^(3) + 5.184 / (1.1)^(4) + 6.2208 / (1.1)^(5) = $ 16.35

Fair Price of Stock = P1 + P2 = 59.35 +16.35 = $ 75.7

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