Question

Since it has been in business, FreeFin has paid $2.20 per share annual dividend to its common stock holders. The company plans to pay the $2.20 dividend next year. The following year it plans to increase the dividend to $2.75 and the year after than it plans to pay a dividend of $3.40. After that, FreeFin plans to increase the dividend by 4.9% each year for the remainder of the company’s life. If investors require a 10% rate of return to purchase FreeFin’s common stock: A. What should be the market value of its stock today? B. What is the dividend yield that will be generated this year (year 1)? C. What is the capital gains yield that will be generated this year (year 1)? D. What is the total yield that will be generated this year (year 1)?

Answer 1

A.Market Value of stock is equal to the present value of all future dividends

= 2.20/(1.1) + 2.75/(1.1)² +3.40/(1.1)³ + 3.40(1+0.049)(10%-4.9%)*(1.1)³

= $59.37

Dividend yield in year 1 = dividend in year 1/Current Market Price

= 2.20/59.37

= 3.71%

c.value of stock at the end of year 1 = 2.75/(1.1)¹ +3.40/(1.1)² + 3.40(1+0.049)(10%-4.9%)*(1.1)²

= $63.11

Capital Gains yield = (63.11-59.37)/59.37 = 6.30%

Total yield = dividend yield + capital gains yield

= 3.71% + 6.30%

=10.01%