What would an investor be willing to pay for common stock in a firm that is expe

Question

What would an investor be willing to pay for common stock in a firm that is expected to pay an annual dividend that will grow at 10 percent over the next 2 years, then grow at 5 percent for 3 years and then stop growing (i.e., will grow at zero percent) from then on? The firm just paid its dividend of $2.00. Thus, if an investor buys this stock, they will not receive the dividend that was just paid. The next dividend will be paid in one year. The required rate of return is an effective annual rate of 10%.

Explanation / Answer

this is done by adding all the present values of future dividends, first two yrs, dividend mult by 1.1, 10% growth rate, next 3 yrs, 5%, multiply by 1.05

= 2/1.1 + 2.2/(1.1)2 + 2.42/(1.1)3 + 2.53/(1.1)4 + 2.66/(1.1)5 + 2.79/(1.1)6 =

= 6/1.1 + 2/1.1 [0.9545 + 0.9111 + 0.8682] = $ 10.4245

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