Assume that the average firm in your company\'s industry is expected to grow at

Question

Assume that the average firm in your company's industry is expected to grow at a constant rate of 6% 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

Required rate of return = Dividend yield + growth rate

= 8% + 6% = 14%

There is an unusual growth in dividend for 2 years after that the firm' stock will grow at industry average i.e 6%

So, Dividend after 1 year, D1 = 2 x 1.5 = $3

Dividend after year 2, D2 = 3 x 1.25 = $3.75

Value of the stock = 3 / (1.14)^1 + 3.75 / (1.14)^2 = $5.517

This is the answer as it is no where mentioned that after second year the firm will have a constant growth rate like the industry average. If the firm will have a constant grwoth rate after second year, then the calculations would differ in the following manner:

Dividend after year 3, D3 = 3.75 x 1.06 = 3.975

Here, we apply the dividend growth model and the price of he stock in year 3 = 3.975 x (1.06) / 0.14 - 0.06

= 4.2135 / 0.08 = 52.66875

so, the value of stock today = 52.66875 + 5.517 = 58.18575

or = $58.19

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