Question

A company has just paid its first dividend of $3.45. Next year's dividend is forecast to grow by 5 percent, followed by another 5 per cent growth in year two. From year three onwards dividends are expected to grow by 2.8 percent per annum, indefinitely. Investors require a rate of return of 15 percent p.a. for investments of this type. The current price of the share is (round to nearest cent)

Select one:

a. $30.26

b. $27.38

c. $13.84

d. $15.37

Answer 1

Option A is correct.

Dividend just paid = $ 3.45 = D0

D1 = 3.45 * (1+g) = 3.45 * (1.05) = $ 3.6225

D2 = D1 * (1+g) = 3.6225 * 1.05 =$ 3.8036

from D3 growth rate is 2.8% indefinitely.

So, value of stock at end of D2 = D2 * ( 1+g) / (r - g)

= 3.8036 * (1.028) / 0.15-0.028

= 3.9101 / 0.122 = $ 32.02

Current price of stock means present value of all discounted cash flows from stock.

Current price = 3.6225 / 1.15 + 3.8036 / 1.152 + 32.02 /1.152

Current price = 3.15 + 2.8761 + 24.2117

Current stock price = $ 30.24 = $ 30.26

Option A is correct