Question

Use the following information to answer the next question.

·       The last dividend paid by Klein Company was $1.00.

·       Klein's growth rate is expected to be a constant 20% for 3 years, after which dividends are expected to grow at a rate of 4% forever.

·       Klein's required rate of return on equity is 10%.

What should be the current price of Klein's common stock?

Select one:

a. $50.16

b. $30.84

c. $36.84

d. $26.08

e. $42.25

Answer 1

Given about Klein Company,

Last dividend paid D0 = $1

growth rate is expected to be a constant 20% for 3 years

So, D1 = D0*1.20 = 1*1.2 = $1.2

D2 = D1*1.2 = 1.2*1.2 = $1.44

D3 = D2*1.2 = 1.44*1.2 = $1.728

thereafter dividends are expected to grow at a rate of 4% forever.

So, g = 4%

required rate of return on equity rs = 10%

So, stock price at year 3 using constant dividend growth rate is

P3 = D3*(1+g)/(rs-g) = 1.728*1.04/(0.10-0.04) = $29.952

Stock price today is sum of PV of all future dividends and P3 discounted at rs

So, P0 = D1/(1+rs) + D2/(1+rs)^2 + D3/(1+rs)^3 + P3/(1+rs)^3

=> P0 = 1.2/1.1 + 1.44/1.1^2 + 1.728/1.1^3 + 29.952/1.1^3 = $26.08

So  current price of Klein's common stock is $26.08

Option d is correct.