The Eastern Company has an expected dividend of S1.25 per share in year 1, follo

Question

The Eastern Company has an expected dividend of S1.25 per share in year 1, followed by a $1.5625 per share dividend in year 2, and S1.953 per share in year 3 with a growth of 5% per year thereafter. The appropriate market capitalization rate is 20% per year 1. What is the intrinsic value of a share of the stock? 2. Assuming current market price of a share is equal to its intrinsic value. Calculate the expected dividend yield (total value of dividends that an investor expects to receive from holding a dividend-yielding stocks). 3. What do you expect its price to be 1 year from now? Is the implied capital gain consistent with your estimate of the dividend yield and the market capitalization rate (expected return on a security)

Explanation / Answer

1)

Present value at year 2 = D3 / k - g

Present value at year 2 = 1.953 / 0.2 - 0.05

Present value at year 2 = 13.02

Present value = 13.02 / ( 1 + 0.2)2

Present value = 9.042

Present value of year 1 dividend = 1.25 / ( 1 + 0.2)

Present value of year 1 dividend = 1.042

Present value of year 2 dividend = 1.5625 / ( 1 + 0.2)2

Present value of year 2 dividend = 1.085

Intrinsic value of share = 1.085 + 1.042 + 9.042

Intrinsic value of share = $11.17

2)

Dividend yield = D1 / current share price

Dividend yield = 1.25 / 11.17

Dividend yield = 0.1119 or 11.19%

3)

Price of year 1 = ( price of year 2 + dividend of year 2) / ( 1 + r)

Price of year 1 = ( 13.02 + 1.5625) / ( 1 + 0.2)

Price of year 1 = $12.152

capital gain = ( 12.152 - 11.17) / 11.17

capital gain = 0.0879 or 8.79%

The sum of the implied capital gains yield and the expected dividend yield is equal to the market capitalization rate. This is consistent with the DDM.

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