Question

QUESTION 28

1. The Felix Corp. projects to its dividends to grow at 20% for the next four years, after which the growth rate will fall to a sustainable rate of 5% per year forever. Assuming that its dividend next year is $2 and that the required return on the stock is 10%, what is the most you would be willing to pay for one share of the company's stock?

   		$54.90
   		$55.90
   		$56.90
   		$57.90
   		$58.90

Answer 1

Price of a stock is the present value of all future cash flows receivable from the stock discounted at required rate of return

Future cash flows are dividends and expected stock price at the end of the year after which dividends are expected to grow at a constant rate

Present value factor

= 1 / (1 + r) ^ n

Where,

r = Rate of interest = 10% or 0.10

n = Years 1 to 4

So, PV Factor for year 2 will be

= 1 / (1.10^2)

= 1 / 1.21

= 0.826446

Expected dividend next year ( D1) = $2

Expected dividend in the second year (D2)

= Previous dividend x (1 + Growth)

= $2 x (1.20) = $2.40

D3 = $2.40 x 1.20

= $2.88

D4 = $2.88 x 1.20

= $3.46

Price of the stock at the end of 4^th year

= D5 / (R – G)

= $3.46 x 1.05 / (0.10 – 0.05)

= $72.58

The following table shows the calculations :

Calculations	A	B	C = A x B
Years	Cash Flow	PV Factor	Present Value
1	2	0.909091	1.818181818
2	2.4	0.826446	1.983471074
3	2.88	0.751315	2.163786627
4	3.46	0.683013	2.360494502
4	72.58	0.683013	49.57038454
		Price	57.90

So, as per above calculations, option D is the correct option