1.a. Consider a stock with a required return of 5 percent and a most recent divi

Question

1.a. Consider a stock with a required return of 5 percent and a most recent dividend of $3.00. It is a growth stock and its dividend will increase by 10% next year and then maintain a constant growth rate thereafter. What is the expected share price now?

b. What will the share price be, if the stock, after increasing the dividend by 10% next year, then reduces the growth rate to 5% after that?

Explanation / Answer

The constant growth model requires that kS > g. Here Ks=5% & g = 10% If g > ks , get negative stock price, which is nonsense. We can’t use model unless (1)kS > g and (2) g is expected to be constant forever. I guess that Ks = 15% & not 5%. Hope it is a typo. So assuming that Ks = 15%, we get We have D0=3.00, Ks=15%, g=10%. What is P0 Using DCF method, we have P0 =D0*(1+g)/(Ks-g) where P0 is current Price of Stock, DO is current DIv =$3.00 g = growth rate of stock = 10% Ks = Stock's rate of return=5% So P0 = 3*(1+10%)/(15%-10%) = $66.00 ....................Ans (1) Here we have SUpergrowth for 1 Year = Gs=10% Then we have normal grwth from Y2 onward as g=5% SO D1= D0*(1+Gs) = 3*(1+10%) = $3.30 D2 = D1*(1+g) = 3.30*(1+5%) = $3.47 a. Terminal or Horizon date is at end of 1 Yrs when Non-constant growth stops. b. After 1 yrs, supernatural growth is over and after that normal growth of 5% starts till infinity D2 = D1*(1+g) = 3.30*(1+5%) = $3.47 When normal growwth starts, So P1 = D2/(Ks-g) = 3.47/(15%-5%) = $34.70 So P0 = (P1+D1)/(1+Ks)^1 = (34.70+3.30)/(1+15%)^1 = $33.04 ..........Ans (2)

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