Question

A company has just paid its first dividend of $3.03. Next year's dividend is forecast to grow by 9 percent, followed by another 9 per cent growth in year two. From year three onwards dividends are expected to grow by 2.5 percent per annum, indefinitely. Investors require a rate of return of 14 percent p.a. for investments of this type. The current price of the share is (round to nearest cent)

Answer 1

g1 = growth rate = 9%

g2 = growth rate = 2.5%

r = required return = 14%

Current Dividend = D0 = $3.03

Dividend in Year 1 = D1 = D0*(1+g1) = $3.03 *(1+9%) = $3.3027

Dividend in Year 2 = D2 = D1*(1+g1) = $3.3027 *(1+9%) = $3.599943

Dividend in Year 3 = D3 = D2*(1+g2) = $3.599943 *(1+2.5%) = $3.689942

Horizon Value = D3 / (r - g2)

= $3.689942 / (14%-2.5%)

= $32.08645

Current Price of share = [D1 / (1+r)^1] + [D2 / (1+r)^2] + [Horizon Value / (1+r)^2]

= [$3.3027 / (1+14%)^1] + [$3.599943 / (1+14%)^2] + [$32.08645 / (1+14%)^2]

= [$3.3027 / 1.14] + [$3.599943 / 1.2996] + [$32.08645 / 1.2996]

= $2.897105 + $2.770039 + $24.68948

= $30.35662

Therefore, Current price of stock is $30.36