The preferred stock of Company A pays a constant $1.00 per share dividend. The c

Question

The preferred stock of Company A pays a constant $1.00 per share dividend. The common stock of Company B just paid a $1.00 dividend per share, but its dividend is expected to grow at 4 percent per year forever. Company C common stock also just paid a dividend of $1.00 per share, but its dividend is expected to grow at 10 percent per year for five years and then grow at 4 percent per year forever. All three stocks have a 12 percent required return. How much should you be willing to pay for a share of each stock? Which stock will give you the best return? Explain

Explanation / Answer

Company A = 1 / 12 % = $8.33 per share Company B = $1 (1 + 0.04) / 0.12 - 0.04 = $13 per share Company C = D0= $1, D1= $1.1, D2= $1.21, D3=$1.33, D4= 1.46, D5= $1.61 P5 = 1.61 (1 + 0.4)/0.12 - 0.04 = $20.93 Current Price = (1.61+20.93) / (1.12)^5 + 1.46 / (1.12)^4 + 1.33 / (1.12)^3 + 1.21 / (1.12)^2 + 1.1/1.12 22.54/1.7623416832 + 1.46/1.57351936 + 1.33/1.404928 + 1.21/1.2544 + 1.10/1.12 = $16.61 per share Willing to pay: CompanyA = $8.33 CompanyB = $13 CompanyC = $16.61 Best return is provided by Company C, as its dividend growth rate is 10% in next 5 years and further 4%, which above other companies.

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