Question

You own a company that competes with Old World DVD Company. Instead of selling DVDs, however, your company sells music downloads from a Web site. Things are going well now, but you know that it is only a matter of time before someone comes up with a better way to distribute music. Your company just paid a $3.38 per share dividend, and you expect to increase the dividend 11 percent next year. However, you then expect your dividend growth rate to begin going down—to 6 percent the following year, 2 percent the next year, and to -2 percent per year thereafter. Based upon these estimates, what is the value of a share of your company’s stock? Assume that the required rate of return is 15 percent. (Round dividends in intermediate calculations to 4 decimal places, e.g. 1.5325 and final answer to 2 decimal places, e.g. 15.25.)

Value of a share

$

Answer 1

Current Dividend, D0 = $3.38

Growth rate for year 1 is 11%, for year 2 is 6%, for year 3 is 2% and a constant growth rate (g) of -2% thereafter

D1 = $3.3800 * 1.11 = $3.7518
D2 = $3.7518 * 1.06 = $3.9769
D3 = $3.9769 * 1.02 = $4.0564
D4 = $4.0564 * 0.98 = $3.9753

Required Return, rs = 15%

P3 = D4 / [rs - g]
P3 = $3.9753 / [0.15 - (-0.02)]
P3 = $3.9753 / 0.17
P3 = $23.3841

P0 = $3.7518/1.15 + $3.9769/1.15^2 + $4.0564/1.15^3 + $23.3841/1.15^3
P0 = $24.31

Therefore, the value of a share is $24.31