Question

(ii) Presently, Stock A pays a dividend of $2.00 a share, and you expect the dividend to grow rapidly for the next four years at 20 percent. Thus the dividend payments will be
       Year      Dividend
         1        $1.20
         2         1.44
         3         1.73
         4         2.07

After this initial period of super growth, the rate of increase in the dividend should decline to 8 percent. If you want to earn 12 percent on investments in common stock, what is the maximum you should pay for this stock?

Answer 1

Answer:

Value for the super growth period

Year	Dividend	PV @ 12%	Discounted Values
1	1.20	0.8929	1.0715
2	1.44	0.7972	1.1480
3	1.73	0.7118	1.2314
4	2.07	0.6355	1.3155
			4.7663 (Step 1)

Now, dividend in year 5 = 2.07*1.08 = 2.24
Price at year 4 = 2.24 / (0.12 - 0.08) = $56
Price now = 56 / (1.12)^4 = $35.59 (Step 2)

Current Price (i.e. the maximum you should pay for this stock) = Step 1 + Step 2
Therefore, Current Price = 4.7663 + 35.59 = $40.3563 (or $40.36 when rounded off to two decimal places)