Assume that the average firm in your company\'s industry is expected to grow at
ID: 2730410 • Letter: A
Question
Assume that the average firm in your company's industry is expected to grow at a constant rate of 5% and that its dividend yield is 8%. Your company is about as risky as the average firm in the industry and just paid a dividend (D0) of $2. You expect that the growth rate of dividends will be 50% during the first year (g0,1 = 50%) and and 25% during the second year (g1,2 = 25%). What is the required rate of return on your company’s stock? What is the estimated value per share of your firm’s stock?
$
Explanation / Answer
Cost of equity = dividend yield + growth rate
= 8%+5%
= 13%
We have:
Do = 2
D1 = 2 x (1+0.50) = 3
D2 = 3 x (1+0.25) = 3.75
Now we need to compute price of the stock at the end of year 2:
P2 = D2 x (1+g)/ (R-g)
= 3.75 x (1+ 0.05)/ (0.13-0.05)
= 49.22
Now we need to compute the PV of all future dividends and prices to get the current value of the stock:
Year
Cash flow
PV factor 13%
PV
1
3
0.884955752
2.65
2
3.75
0.783146683
2.94
2
49.22
0.783146683
38.55
44.14
Therefore, current stock value would be 44.14.
Year
Cash flow
PV factor 13%
PV
1
3
0.884955752
2.65
2
3.75
0.783146683
2.94
2
49.22
0.783146683
38.55
44.14
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