Question

MBA Inc is expected to have dividend distribution policies as below:
- MBA Inc will pay out cash dividend £1 per share per year in the next two years
- In the end of the 3rd year, MBA Inc will pay out cash dividend £2 per share
- From the end of the 3rd year, MBA Inc will continuously pay cash divided at 5% constant growth rate per annum

What is the theoretical price of stock of MBA Inc if the required rate of return is 10% per annum? Please show your working.

Answer 1

The value of stock is equal to present value of all the dividends to be paid in the future.

According to constant growth model, the value of stock can be obtained as under:

P0 = D1/(r-g)

Here, P0 is the price of stock today, D1 is the dividend to be received next year, r is the discount rate and g is the constant growth rate of dividend.

As per question, the price of stock today will be as under

D1/(1+discount rate) + D2/(1+discount rate)^2 + D3/[(discount rate - growth rate)*(1+discount rate)^2]

The last term uses the constant growth model formula to calculate the value of all future dividends at year 2 and then discounting is done to obtain the value today.

Thus, price of stock = 1/(1.10) + 1/(1.10^2) + 2/[(0.10-0.05)*(1.10^2)]

Price = 1.735537 + 33.05785

Price = 34.7934

Thus, the price should be 34.79 pounds.

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