ABC is a young start-up company. No dividends will be paid on the stock over the...

ABC is a young start-up company. No dividends will be paid on the stock over the next 3 years because the firm needs to plow back its earnings to fuel growth. The company plans to pay a $6 per share dividend in 4 years and will increase the dividend by 4 percent per year thereafter. What is the current share price if the required return on this stock is 16 percent?

Expert Solution

answer is 32.03

Here we have a stock that pays no dividends for 4 years. Once the stock begins paying dividends, it will have a constant growth rate of dividends. We can use the constant growth model at that point. It is important to remember that general form of the constant dividend growth formula is:

Pt= [Dt(1 + g)] / (r– g)

This means that since we will use the dividend in Year 4, we will be finding the stock price in Year 3. The dividend growth model is similar to the PV of an annuity and the PV of a perpetuity: The equation gives you the PV one period before the first payment. So, the price of the stock in Year 3 will be:

P3= D4/(r– g) = $6.00/(0.16–0.04) = $50.00

The price of the stock today is simply the PV of the stock price in the future. We simply discount the future stock price at the required return. The price of the stock today will be:

P0= $50.00/(1.16)3

=$50.00 / 1.560896

= $32.03

thank you so much

please comment for any further help?

jeff jeffy answered 8 months ago

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