Question

1. ABC Company is experiencing a rapid growth. The first dividend will be paid next year (at year . After that, dividends are expected to grow at 20% per year during the next two years (years 2 and 3), and then 5% per year indefinitely. The required rate of return on this stock is 15%, and the stock is currently selling for 50TL.

1. What is the expected dividend for the coming year (Div₁)? (5 points)

2. What is the expected price of this stock at the end of year 1? (

3. If you purchase this stock today and sell it after receiving the dividend at the end of year 1, what is your expected rate of return? How much of this return is coming from capital gains?

Answer 1

a). Solution :- Expected dividend for coming year = Current stock price * required return on stock.

= 50 TL * 15 %

= 7.50 TL.

Conclusion :- Expected dividend for coming year (D₁) = 7.50 TL

b). Solution :- Expected dividend during year 2 (D₂) = 7.50 * (1 + 0.20) [ D₂ = D₁ * (1 + Growth in dividends) ]

= 7.50 * 1.20

= $ 9.

Expected dividend during year 3 (D₃) = 9.00 * (1 + 0.20)   [ D₃ = D₂ * (1 + Growth in dividends) ]

= 9.00 * 1.20

= $ 10.80.

Expected dividend during year 4 (D₄) = 10.80 * (1 + 0.05)    [ D₄ = D₃ * (1 + Growth in dividends) ]

= 10.80 * 1.05

= $ 11.34

Price of stock at end of Year 3 (P₃) = D₄ / (Required return - Growth in dividends)

= 11.34 / (0.15 - 0.05)

= 11.34 / 0.10

= $ 113.40

Price of stock at end of Year 1 (P₁) = 9 / (1.15)^2-1 + (10.80 + 113.40) / (1.15)^3-1

= 9 / (1.15)¹ + 124.20 / (1.15)²

= 9 / 1.15 + 124.20 / 1.3225

= 7.83 + 93.91

= $ 101.74

Conclusion :- Price of stock at end of Year 1 = $ 101.74 (approx).

c). Expected return = (Expected dividend in year 1 / Current stock price) * 100.

= (7.50 / 50) * 100

= 0.15 * 100

= 15 %

Conclusion :- Expected return on stock = 15 % (approx).