Question

A company is expecting its sales to decline and has announced that it will be reducing its annual dividend by 7.25% 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 $3.10 per share. What is this stock worth if you require a 11.25% rate of return?

Answer 1

The company paid a dividend of $3.10 per share at year 0

At year 1 , dividend paid = 3.1 * (100 - 7.25)% = 3.1*0.9275 = 2.875

At year 2 , dividend paid = 2.875* (100 - 7.25)% = 2.875*0.9275 = 2.667

Acc to dividend growth model , Terminal value at end of year 2 = Dividend at year 3 / (Required rate of return - constant growth rate)

= 1 / (11.25% - 0) .... ( Since growth rate is constant it is Zero)

= 8.889

The intrinsic value of the stock is calculated in the table below:

(The PV factor is 1/ (1+ 0.1125)^n , where n is the year )

Year	Cash flow(CF)	Present Value factor(PV)	CF*PV
1	2.875	0.899	2.584
2	2.667	0.808	2.155
2 (Terminal Value)	8.889	0.808	7.182
		Total =	11.921

Hence, this stock is worth $ 11.921 at present