Question

Summit Systems has an equity cost of capital of 11.0 %​, will pay a dividend of ​$1.75 in one​ year, and its dividends had been expected to grow by 5.5 % per year. You read in the paper that Summit Systems has revised its growth prospects and now expects its dividends to grow at a rate of 3.5 % per year forever. a. What is the drop in value of a share of Summit Systems stock based on this​ information? b. If you tried to sell your Summit Systems stock after reading this​ news, what price would you be likely to​ get? Why?

Answer 1

	Price of a share, having constant dividend growth is given by:
	P0 = D1/(r-g)
	where,
	P0 = Current price, D1 = Next expected dividend, r = required return
	and g = growth rate
	Hence,
a]	The drop in price = 1.75/(11.0%-5.5%)-1.75/(11.0%-3.5%) =	$               8.48
b]	The price likely to be got = 1.75/(0.11-0.035) =	$             23.33