Question

Phoenix Industries has pulled off a miraculous recovery. Four years ago, it was near bankruptcy. Today, it announced a $1 per share dividend to be paid a year from now, the first dividend since the crisis. Analysts expect dividends to increase by 40 percent a year for 2 years. Dividends are expected to grow at a rate of 15 percent for another 2 years. After the fifth year, dividend growth is expected to settle down to a more moderate long-term growth rate of 5 percent. If the firm’s investors expect to earn a return of 20 percent on this stock, what must be its price?

Answer 1

Given, D1=$1

D2=$1*(1+40%)=$1.4

D3=$1.4*(1+40%)=$1.96

D4=$1.96*(1+15%)=$2.254

D5=$2.254*(1+15%)=$2.5921

Now growth rate settles down at 5%

We have to find the terminal value at Year5=D6/(expected return on equity-growth rate)

D6=$2.5921*(1+5%)=$2.721705

Terminal value at Year5=$2.721705/(20%-5%)=$18.1447

Stock price (P0)=(D1/(1+20%))+(D2/(1+20%)^2)+(D3/(1+20%)^3)+(D4/(1+20%)^4)+(D5+Terminal value at year5)/(1+20%)^5

P0=(1/1.2)+(1.4/1.2^2)+(1.96/1.2^3)+(2.254/1.2^4)+(20.7368/1.2^5)

P0=$12.36