Question

A stock is expected to pay the following dividends: $2.2 two years from now, and $3.3 three years from now, followed by growth in the dividend of 4% per year forever after that point. There will be no dividends prior to year 2. The stock's required return is 13%. The stock's current price (Price at year 0) should be $___________

Answer 1

Given about a stock,

Expected dividend in year 2, D2 = $2.2

Expected dividend in year 3, D3 = $3.3

thereafter growth rate g = 4%

stock's required return rs = 13%

So, stock price at year 2 using constant dividend growth model is

P3 = D3*(1+g)/(rs - g) = 3.3*1.04/(0.13- 0.04) = $38.13

Stock current price P0 is sum of future dividend and P3 discounted at rs

=> P0 = D2/(1+rs)^2 + D3/(1+rs)^3 + P3/(1+rs)^3

=> P0 = 2.2/1.13^2 + 3.3/1.13^3 + 38.13/1.13^3 = $30.44

The stock's current price (Price at year 0) should be $30.44