Question

1. (show step by step calculation and formula, don't use excel or fina calculator.) HappyTea company expects to pay the following dividends over the next four years: $11, $8, $5 and $2. Afterward, the company pledges to maintain a constant 5 percent growth rates in dividends forever. If the required return on the stock is 16 percent, what should the current share price be?

Answer 1

Growth rate (g) = 5% or 0.05

r = 16% or 0.16

D1= $11

D2 = $8

D3 = $5

D4 = $2

D5 = D4 x (1+g)

  = $ 2 x (1+0.05)

= $ 2 x 1.05

= $ 2.1

As per Dividend Discount Model, share price in year 4 is:

P4 = D5/(r-g)

    = $ 2.1/ (0.16-0.05)

    = $ 2.1/0.11

    = $19.090909091

Current Share price P0

= D1/(1+r) + D2/(1+r)2+ D3/(1+r)3+ D4/(1+r)4+ P4/(1+r)4

= $ 11/ (1+0.16) +$ 8/ (1+0.16)2+ $ 5/ (1+0.16)3+ $ 2/ (1+0.16)4+ $19.090909091 / (1+0.16)4

= $ 11/ (1.16) + $ 8/ (1.16)2+ $ 5/ (1.16)3+ $ 2/ (1.16)4+ $ 19.090909091 / (1.16)4

= $ 11/1.16000 + $ 8/1.34560+ $ 5/1.560896+ $ 2/1.810639+ $ 19.090909091 /1.810639

= $ 9.4827586+ $ 5.9453032+ $ 3.2032884+ $ 1.1045822+ $ 10.5437391

= $ 30.27967

= $ 30.28

Current share price of Happy Tea Company is $ 30.28