Question

Non-constant growth model problem Show all work.

Formulas:

DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have been declared as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its supernormal growth. After that, dividends are expected to grow at the firm's normal growth rate of 6 percent. The firm's required rate of return is 18 percent.

A. Draw a timeline of the cash flows for DAA for the next 4 years.

B. Calculate the value of the stock today, Po.

DAA Continued.
C. Is this stock currently fairly priced? Explain.

D. Calculate the dividend yield, capital gains yield and total yield expected in the first year.

E. Based on your computed yields for DAA. What can you conclude about using the dividend model for DAA’s stock and why?

Answer 1

Question - A

Cashflow Timeline

Question No. 02

Dividend in Year -3 = $2

Required Rate of Return = 18%

Growth Rate = 6%

Value of Stock at the end of Year-3 = 2/(0.18-0.06) = $ 16.67

Value of Stock Today = 16.67/(1+0.18)3 = $10.14

Question No. 03

Fair Value of Stock = $ 10.14

Current Selling Price = $ 15.00

The Stock is Overvalued

Question No.04

Value of Stock at the end of Year - 1 = 10.14 * 1.18 = $ 11.97

Dividend Yield = 0%

Capital Gain Yield = (11.97-10.14)/10.14 = 18%

Therefore TOtal Yield = 18%

Question No. 05

Based on the Computed Yield, we can conclude to use dividend model for valuation of Stock, because of the value of increase of stock value at an expected rate.