Computech Corporation is expanding rapidly and currently needs to retain all of

Question

Computech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Computech to begin paying dividends, beginning with a dividend of $0.75 coming 3 years from today. The dividend should grow rapidly-at a rate of 41% per year-during Years 4 and 5; but after Year 5, growth should be a constant 4% per year. If the required return on Computech is 15%, what is the value of the stock today? Round your answer to the nearest cent. Do not round your intermediate calculations.

Explanation / Answer

Price of a stock is the present value of all future cash flows receivable from the stock discounted at required rate of return

Future cash flows are dividends and terminal value at the end of year 5

Cash flow for year 3 (D3) = Dividend $0.75

Cash flow for year 4 (D4) = D3 x (1 + Growth)

= $0.75 x 1.41

= $ 1.0575

Cash flow for year 5 (D5) = D4 x (1 + Growth)

= $ 1.0575 x 1.41

= $ 1.491075

Terminal value at year 5

= D6 / (Re – G)

Where,

D6 = Expected dividend at end of year 6

= D5 x (1 + Growth)

= $ 1.491075 x 1.04

= $ 1.550718

Re = Required rate of return = 15% or 0.15

G = Growth rate = 4% or 0.04

So, Terminal value at end of year 5

= $ 1.550718 / (0.15 – 0.04)

= $14.097436

Present value factor

= 1 / (1 + Re) ^ n

Where,

Re = Required rate of return = 15% or 0.15

n = Years = 3 to 5

So, PV Factor for year 3

= 1 / 1.15^3

= 1 / 1.520875

= 0.657516

So, Price of the stock is calculated in the following table

So, the price of the stock is $8.8

Calculations A B C = A x B Year Cash Flow PV Factor Present Value 3 0.75 0.657516 0.493137 4 1.0575 0.571753 0.604629 5 1.491075 0.497177 0.741328 5 14.09744 0.497177 7.008917 Price 8.8

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