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 7%. Your company is about as risky as the average firm in the industry and just paid a dividend of $1. You expect that the growth rate of dividends will be 50% during the first year and 25% during the second year. After Year 2, divdend growth will be constant at 6%. 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

Reqd. rate of return=growth rate(g) + Dividend/Market price(dividend yield) So,Required rate of return= Constant growth rate+ Dividend yield ie. 6%+7%=13% Estimated value of the stock is the Sum of the PRESENT VALUES of future cash flows from holding the stock, in the form of dividends. So, First, dividends for 1st 2 years are calculated & in year 3, (period of constant growth, Terminal cash flow is calculated. & All cash flows are dicounted @ the reqd.rate of return -13% & PVs are found. The sum is the current stock Price Year Dividend Cash flows in the form of dividends PV F @ the reqd. rate of return ie. 13% PV of cah flows 0 1 1 1 1*1.5 1.5 0.88496 1.32744 2 1.5*1.25 1.875 0.78315 1.468406 2 (1.875*1.06)/(0.13-0.06) 28.39286 0.78315 22.23587 Estimated value per share of the firm's stock is the total of the PV of these cash flows dicounted @ the req. rate of return ie. 13%     = 25.03171 ie. $ 25.03 Working notes: Div.(3)=1.875*1.06=1.9875 Cash flow @ end of year 2= 1.9875/(0.13-0.06) Next yr. div/(reqd.rate-growth rate)

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