Question

Dino Co. is a new education consulting firm that just paid its annual dividend of $1.00 yesterday. Analyst believe that due to a special one-time boost in revenue, the following year’s dividend (t=1) will be $3.50. Dividends will decline at a 30% rate for 2 years, after which point they will grow at a steady rate of 3% forever. Similar firms in the industry have a 20% cost of capital associated with them.

1) What is the dollar amount of the dividend at the end of year 3 (t=3), round to the nearest penny?

2) What is the per-share value of the stock, round to the nearest penny?

Using the information as in parts 1 and 2, and the calculated share price from part 2:

3) You are offered the chance to buy shares in Dino Co. for $11.75 per share. Should you purchase shares? Would you answer change if you felt Dino Co. would have a 10% cost of capital? Why/why not?

Answer 1

1)

dividend at (t = 1) given = 3.5

dividend at (t = 2) = 3.5 *(1 - 0.3) = 2.45

dividend at (t = 3) = 2.45*(1 - 0.3) = $1.715

so dollar amount of dividend at (t = 3) = $1.715

2)

value of the stock = present value of future dividends discounted at cost of capital(20%)

continuous value = dividend at (t = 3)[1+ growth] / K - g

= 1.715(1+3%) / 0.2 - 0.03

= 10.39

share price = 3.5 / (1.2) + 2.45 / (1.2)^2 + 1.715 / (1.2)^3 + 10.39 / (1.2)^3

= $11.62

3)

worth of the share as per calculation is $11.62 only. $11.75 is over priced so it is not recommended to buy

in case of 10% cost of capital

continuous value = dividend at (t = 3)[1+ growth] / K - g

= 1.715(1+3%) / 0.1 - 0.03

= 25.235

share price = 3.5 / (1.1) + 2.45 / (1.1)^2 + 1.715 / (1.1)^3 + 25.235 / (1.1)^3

= $25.45

since offer price of $11.75 is less than calculated value, we can buy the share.