Question

1. Paulina Cocoa Company currently pays a dividend of Ȼ1.60 per share on its common stocks. The company expects to increase the dividend at a 20 percent annual rate for the first three years and at a 13 percent rate for the next three years and grow the dividend at a 7 percent rate thereafter. This phased- growth pattern is in keeping with the expected life cycle of earnings. You require a 16 percent return to invest in this stock. What is the most you will pay for this stock?

Answer 1

we are given,

D0 = $1.6

Growth rate in Initial growth period(IGP) of 3 yrs = 20%

Growth rate from yr 4 to 6 = 13%

constant growth rate = 7%

required return(r) = 16%

D1 = D0*(1+g) = 1.6*1.2 = 1.92

D2 = D1*(1+g) = 1.92*1.2 = 2.3

D3 = D2*(1+g) = 2.3*1.2 = 2.76

D4 = D3*(1+g) = 2.76*1.13 = 3.12

D5 = D4*(1+g) = 3.12*1.13 = 3.53

D6 = D5*(1+g) = 3.53*1.13 = 3.99

According to Dividend discount model,

Price in yr 6 = D6*(1+g)/(r-g) = 4.26/0.09 = 47.42

Current price = Price in yr 6/(1+r)^6 = 19.46

Hence the most that we will pay for this stock currently is 19.46

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