Question

Alfonso Ltd will not pay dividends until year 3, whereby it is expected to pay $5 in dividends. Dividends are then expected to grow at 20%, 10% and 5% in years 4, 5 and 6. Afterwards, dividend growth will stabilize to 2% consistently. If the rate of return is 10%, determine the stock price in year 3. (With all the FORMULAS AND STEPS)

Answer 1

The price is computed as shown below:

= Dividend in year 4 / (1 + rate of return)¹ + Dividend in year 5 / (1 + rate of return)² + Dividend in year 6 / (1 + rate of return)³ + 1 / (1 + rate of return)³ x [ (Dividend in year 6 x (1 + growth rate) / (rate of return - growth rate) ]

= ($ 5 x 1.20) / 1.10 + ($ 5 x 1.20 x 1.10) / 1.10² + ($ 5 x 1.20 x 1.10 x 1.05) / 1.10³ + 1 / 1.10³ x [ ($ 5 x 1.20 x 1.10 x 1.05 x 1.02) / (0.10 - 0.02) ]

= $ 6 / 1.10 + $ 6.60 / 1.10² + $ 6.93 / 1.10³ + 1 / 1.10³ x [ ($ 88.3575) ]

= $ 6 / 1.10 + $ 6.60 / 1.10² + $ 95.2875 / 1.10³

= $ 82.50

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