Question

ABC has experienced a period of declining earnings performance due to new competitors. ABC has just announced a restructuring plan calling for the suspension of its annual dividend for the next 2 years. ABC will use these funds instead to invest in new equipment which it hopes will lead to improved efficiencies and lower costs. Analysts believe that when the company resumes paying its dividend 3 years from today that it will be $1.50/ share. The dividends are then expected to grown at an annual rate of 15% for the following 3 years. Starting in year 7, the dividends will then be expected to grow at a constant rate of 5% in perpetuity. The current price of ABC’s stock is $16.35. Would you buy this stock if you have a required rate of return of 15%. Select one: a. No b. Yes c. Indifferent

Answer 1

a. No

Using dividend discount model, we can calculate the present value of the stock as: D3/(1+r)^3+D4/(1+r)^4+D5/(1+r)^5+D6/(1+r)^6+(D7/(r-g)/(1+r)^6); where D3 to D6 are dividends paid from Year3 to Year7, r is required rate of return and g is perpetual growth rate of dividends from Year7.

Given D3= $1.5

D4= 1.5*1.15

D5= 1.5*1.15^2

D6= 1.5*1.15^3

D7= 1.5*1.15^3*1.05

So, present value of the stock= (1.5/1.15^3)+(1.5*1.15/1.15^4)+(1.5*1.15^2/1.15^5)+(1.5*1.15^3/1.15^6)+((1.5*1.15^3*1.05)/(15%-5%))/1.15^6

= $14.30

As present value of the stock is less than the current price, we will not buy the stock.