Question

Bobby Bonilla Sports Inc is a growing firm that just paid a dividend on its common stock of $0.35 per share. Estimates of future dividend payments are as follow: One year from today, $1.25 per share, Two years from today $1.90 per share, Three years from today $2.40 per share. After the 3rd year (payment of $2.40) dividends are expected to grow at a rate of 5% per year henceforth. If the appropriate rate of return for the risks of owning the stock is 13.5%, what should be the stock price (rounded to two decimal places)

Answer 1

We can do the problem in 3 steps:

Step 1: Find D₁, D₂, D₃ and D₄

D₁ = $1.25 (given)
D₂ = $1.90 (given)
D₃ = $2.40 (given)

D₄ = D3 + g ..................( g is the growth rate)
= $2.40 + ($2.40 * 5%)
= $2.40 + $0.12
= $2.52

Step 2: Find the stock price in year 3.

We have stock price formula:

Where,
V₃ = Stock price in year 3
D₄ = Expected Dividend in year 4
R = Required rate of return
g = Dividend growth rate after year 3.

Therefore,

Step 3: Find the present value of D₁, D₂, D₃, and V₃.

Sum of present value will be the current stock price discounted with the required rate of return:

Therefore, the stock price should be $24.49