Question

1. Assume that the average firm in Masters Corporation’s industry is expected to grow at a constant rate of 3% and that its dividend yield is 5%. Masters is about as risky as the average firm in the industry and just paid a dividend (D₀) of $2.5. Analysts expect that the growth rate of dividends will be 25% during the first year (g_0,1 = 25%) and 10% during the second year (g_1,2 = 10%). After Year 2, dividend growth will be constant at 5%. What is the required rate of return on Masters’s stock? What is the estimated intrinsic per share?

Answer 1

Required Rate of Return, rs = Growth Rate + Dividend Yield
Required Rate of Return, rs = 3.00% + 5.00%
Required Rate of Return, rs = 8.00%

Last Dividend, D0 = $2.50

Growth rate for first year is 25%, for second year is 10% and a constant growth rate (g) of 5% thereafter

D1 = $2.5000 * 1.25 = $3.1250
D2 = $3.1250 * 1.10 = $3.4375
D3 = $3.4375 * 1.05 = $3.609375

P2 = D3 / (rs - g)
P2 = $3.609375 / (0.08 - 0.05)
P2 = $3.609375 / 0.03
P2 = $120.3125

P0 = $3.125/1.08 + $3.4375/1.08^2 + $120.3125/1.08^2
P0 = $108.99

Intrinsic Value per share = $108.99