Question

Bobster Corp., which is only ten years old, has never paid a dividend. Based on your analysis, you think it will pay the following dividends in the future:

• $1 one year from now

• $3 two years from now

• $5 three years from now

Other points:

• After the $5 dividend, you expect dividends to grow at a rate of 5% for the foreseeable future.

• After the dividend at the end of the fifth year, you think that the market will require a rate of return of 12% because you think the market will recognize the future growth and stability of the company at that time.

• At that point (after the dividend at the end of the fifth year), you will sell the stock.

• Because Bobster is not a mature company and has never paid a dividend, you require a rate of return on your 5-year investment of 35%.

How much are you willing to pay for the stock?

Answer 1

The amount to be paid with a target return of 35% will be present value of all dividends and terminal value discounted at 35%.

PV of Dividend in Year 1 = $1/1.35¹ = $0.7407
PV of Dividend in Year 2 = $3/1.35² = $1.6461
PV of Dividend in Year 3 = $5/1.35³ = $2.0322

Terminal Value = [(Dividend in Year 3)*(1+Constant Growth Rate)]/[Cost of equity - Constant Growth Rate]
=> ($5*1.05)/(0.12-0.05) = $75

PV of Terminal Value = $75/1.35³ = $30.4832

Maximum amount to be paid for the stock = $0.7407 + $1.6461 + $2.0322 + $30.4832 = $34.9022