Question

CONSTANT GROWTH VALUATION

Holtzman Clothiers's stock currently sells for $26 a share. It just paid a dividend of $1.25 a share (i.e., D₀ = $1.25). The dividend is expected to grow at a constant rate of 7% a year.

1. What stock price is expected 1 year from now? Round your answer to two decimal places.
   $
   
2. What is the required rate of return? Round your answer to two decimal places. Do not round your intermediate calculations.
   %

Answer 1

Formula of constant dividend growth model is as below:

P₀ = D₁/(r-g)

Where, P₀ = current stock price, D₁ = expected dividend next year, r = required rate of return and g = dividend growth rate

D₁ = D₀ * (1+dividend growth rate) = $1.25*(1+0.07) = $1.25*1.07 = $1.3375

First required rate of return needs to calculated using the above formula.

b. $26 = $1.3375/(r - 0.07)

$26r - $26*0.07 = $1.3375

$26r = $1.3375 + $1.82

r = $3.1575/$26 = 0.1214 or 12.14%

a. stock price expected in one year from now

P₁ = D₁*(1+dividend growth rate)/(r - g)

P₁ = $1.3375*1.07/(0.1214 - 0.07)

P₁ = $1.431125/0.0514 = $27.84