Question

Big Red Machines, a startup, has come up with a new product and has seen significant customer demand. Due to reinvestment in the firm (100% plowback ratio) Big Red Machines will pay no dividends in the first 2 years. Beginning in the 3rd through 6th years, the firm expects to pay $1.50, $1.60, and $1.75 In the 6th year, the firm should see stable growth rates and thus begin a divided which grows at 3% per year. You plan to graduate 1 year from now, and hope to invest in Big Red Machines at that time. The expected rate of return is 8% What is the value of Big Red Machine's stock one year from today? ; Do not round your intermediate calculations. Round your final answer to two decimal places.

Answer 1

The value of the stock is computed as shown below:

= Dividend in year 3 / (1 + required rate of return)² + Dividend in year 4 / (1 + required rate of return)³ + Dividend in year 5 / (1 + required rate of return)⁴ + 1 / (1 + required rate of return)⁴ [ ( Dividend in year 5 (1 + growth rate) / ( required rate of return - growth rate) ]

= $ 1.50 / 1.08² + $ 1.60 / 1.08³ + $ 1.75 / 1.08⁴ + 1 / 1.08⁴ x [ ($ 1.75 x 1.03) / (0.08 - 0.03) ]

= $ 1.50 / 1.08² + $ 1.60 / 1.08³ + $ 1.75 / 1.08⁴ + $ 36.05 / 1.08⁴

= $ 1.50 / 1.08² + $ 1.60 / 1.08³ + $ 37.80 / 1.08⁴  

= $ 30.34