Question

The VSE Corporation currently pays no dividend because of depressed earnings. A recent change in management promises a brighter future. Investors expect VSE to pay a dividend of $1.25 next year (the end of year 1). This dividend is expected to increase to $2.25 the following year and to grow at a rate of 11 percent per annum for the following 2 years (years 3 and 4). Chuck Brown, a new investor, expects the price of the stock to increase 40 percent in value between now (time zero) and the end of year 3. If Brown plans to hold the stock for 2 years and requires a rate of return of 20 percent on his investment, what value would he place on the stock today? Use Table II to answer the question. Do not round intermediate calculations. Round your answer to the nearest cent.

$  

Answer 1

Solution) Assume dividend will grow at 11% forever after 4 years
Calculation for value of stock
D₁ = $ 1.25
D₂ = $ 2.25
D₃ = D₂(1.11) = $ 2.25(1.11) = $2.4975
D₄ = D₃(1.11) = $ 2.4975(1.11) = $2.77225
P₃(Present Value of all the dividend after 3 years till perpuity at the 3rd year) = D₄/(K_e - g) = 2.77225/(0.2-0.11)
= 2.77225/(0.09) = 30.80277
K_e = 20%
Value of Stock Now (P₀) = D₁/(1+K_e)¹ + D₂/(1+K_e)² + D₃/(1+K_e)³ + P₃/(1+K_e)³
= 1.25/(1.20)¹ + 2.25/(1.20)² + 2.4975/(1.20)³ + 30.802777/(1.20)³
= 1.041667 + 1.5625 + 1.445313 + 17.8291533
= 21.8786333