Question

Phoenix Industries has pulled off a miraculous recovery. Four years ago it was near bankruptcy. Today, it announced a $2 per share dividend to be paid a year from now, the first dividend since the crisis. Analysts expect dividends to increase by $1 a year for another 2 years. After the third year (in which dividends are $4 per share) dividend growth is expected to settle down to a more moderate long-term growth rate of 5%. If the firm’s investors expect to earn a return of 12% on this stock, what must be its price?

Answer 1

The price is computed as shown below:

The value of the stock is computed as shown below:

= Dividend in year 1 / (1 + required rate of return)¹ + Dividend in year 2 / (1 + required rate of return)² + Dividend in year 3 / (1 + required rate of return)³ + 1 / (1 + required rate of return)³ [ ( Dividend in year 3 (1 + growth rate) / ( required rate of return - growth rate) ]

= $ 2 / 1.12 + $ 3 / 1.12² + $ 4 / 1.12³ + 1 / 1.12³ [ ( $ 4 (1 + 0.05) / ( 0.12 - 0.05) ]

= $ 2 / 1.12 + $ 3 / 1.12² + $ 4 / 1.12³ + $ 60 / 1.12³

= $ 49.73 Approximately

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