Question

Orwell building supplies' last dividend was $1.75. Its dividend growth rate is expected to be constant at 40.00% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (r_s) is 12%. What is the best estimate of the current stock price?

Select the correct answer.

a. $55.81

b. $54.95

c. $52.37

d. $53.23

e. $54.09

Answer 1

Step-1, Dividend per share for the first 2 years

Dividend in Year 1 (D1) = $2.45 per share [$1.75 x 140%]

Dividend in Year 2 (D2) = $3.43 per share [$2.45 x 140%]

Step-2, Calculation of Stock Price in Year 2 (P2)

Stock Price in Year 2 = D2(1 + g) / (Ke – g)

= $3.43(1 + 0.06) / (0.12 – 0.06)

= $3.64 / 0.06

= $60.60 per share

Step-3, Current Stock Price

The Current Price of the stock is the aggregate of present value of the 2 year dividends plus stock price in year 2

Price of the Stock = D1/(1 + Ke)¹ + D2/(1 + Ke)² + P2/(1 + Ke)²

= $2.45/(1 + 0.12)¹ + $3.43/(1 + 0.12)² + $60.60/(1 + 0.12)²

= [$2.45 / 1.12] + [$3.43 / 1.2544] + [$60.60 / 1.2544]

= $2.19 + $2.73 + $48.31

= $53.23 per share

“Therefore, the Current Stock Price = (d). $53.23”