Question

A company is expecting its sales to decline and has announced that it will be reducing its annual dividend by 4.50% a year for the next two years. After that, it will maintain a constant dividend of $1.00 a share. Just recently, the company paid a dividend of $2.00 per share. What is this stock worth if you require a 8.50% rate of return?

Answer 1

Given about a company,

Most recent dividend D0 = $2

dividend are expected to decrease at the rate of 4.50% a year for next 2 years

So, D1 = 2*(1-0.045) = $1.91

D2 = 1.91*(1-0.045) = $1.8241

thereafter, company will maintain constant dividend of D = $1

required rate of return r = 8.55%

So, Value of stock at year 2 using perpetual model is

P2 = D/r = 1/0.085 = $11.7647

So, present value of stock is sum of PV of future dividends and P2 discounted at r

=> P0 = D1/(1+r) + D2/(1+r)^2 + P2/(1+r)^2

=> P0 = 1.91/1.085 + 1.8241/1.085^2 + 11.7647/1.085^2 = $13.30

So, current market value of this stock is $13.30