Question

Jungle Juice Ltd (JJL) is a young company that currently does not pay a dividend as the company retains all its earnings to finance its growth. Market analysts expect that at the end of year 5 the company will start paying a $1.50 dividend. They also expect this dividend to grow by 5% p.a. over the foreseeable future after that. The required return on the shares is 15%. Based on this information, JJL’s share price immediately after the first dividend is paid should be closest to:

a) $7.83.

b) $8.58.

c) $15.00.

d) $15.75.

Answer 1

Information provided:

Dividend= $1.50

Growth rate= 5%

Required rate of return= 15%

The question is solved using the dividend discount model.

Price of the stock= D1/(r-g)

where

D1=next dividend payment

r=interest rate

g=firm’s expected growth rate

Price of the stock= $1.50*(1+ 0.05)/ 0.15 – 0.05

                               = $1.5750/ 0.10

                                 = $15.75.

Therefore, the price of the stock immediately after the first dividend is $15.75.

Hence, the answer is option d.

In case of any query, kindly comment on the solution.