Question

The dividend for Should I, Inc., is currently $1.20 per share. It is expected to grow at 20 percent next year and then decline linearly to a perpetual rate of 5 percent beginning in four years. If you required a return of 16 percent on the stock, what is the most you would pay per share? (Do not round intermediate calculations. Round your answer to 2 decimal places.) The answer is not 4.70

Answer 1

Current dividend, D0 = $1.20

Growth rate in Year 1 is 20%, growth rate in Year 2 is 15%, growth rate in Year 3 is 10% and a constant growth rate (g) of 5% thereafter.

D1 = $1.2000 * 1.20 = $1.4400
D2 = $1.4400 * 1.15 = $1.6560
D3 = $1.6560 * 1.10 = $1.8216
D4 = $1.8216 * 1.05 = $1.91268

Required return, r = 16%

P3 = D4 / (r - g)
P3 = $1.91268 / (0.16 - 0.05)
P3 = $17.3880

P0 = $1.44/1.16 + $1.656/1.16^2 + $1.8216/1.16^3 + $17.388/1.16^3
P0 = $14.78

So, current stock price is $14.78