Question

12. Assume the BonBon Candy Company is a constant growth company whose last dividend was $3,00 and whose dividend is expected to grow indefinitely at 6% rate. It normally discounts all cash flow at 10% .

a. what is the firm’s expected dividend stream over the next three years ?

b. what is the firm’s current stock price ?

c. what is the stoch’s expected value one year from now ?

d. what are the following :

      i. the expected dividend yield during first year ?

      ii. the capital gain yield during the first year ?

      iii. the total return during the first year ?

e. now assume that the stock is currently selling at $79.50 . what is the expected rate of return on the stock?

f. what would the stock price be if its dividends were expected to have zero growth?

Answer 1

As per the values given in the question, the following is available

• Current dividend= $3 per share
• Expected growth rate in dividend in perpetuity= 6% p.a.
• Cost of Equity= 10%

a. The company currently has a dividend of $3 per share and expects dividend to grow constantly at 6% per annum. Therefore the stream of expected dividends during the next 3 years are as follows (All figures rounded to two decimals):

• Year 1= $3*(1+6%)= $3.18
• Year 2= $3.18*(1+6%)= $3.37
• Year 3= $3.3708*(1+6%)= $3.57

b. The company currently has a dividend of $3 per share and expects dividend to grow constantly at 6% per annum. As per Gordon Growth Model, in case dividends are expected to grow at a constant rate till perpetuity, the fair value of a stock can be calculated as follows:

• Price per share= (Expected dividend next year)/ (Cost of equity-constant dividend growth)
• Based on above formula and values provided in the question, the firm's current stock price is calculated as below
  • Price= {3*(1+6%)}/(10%-6%)= $79.50

c. One year from now, the company will have an existing dividend of $3.18 (please refer 'a' above) per share and expected to grow constantly at 6% per annum. As per Gordon Growth Model, in case dividends are expected to grow at a constant rate till perpetuity, the fair value of a stock can be calculated as follows:

• Price per share= (Expected dividend in next year)/ (Cost of equity-constant dividend growth)
• Based on above formula and values provided in the question, the stock's expected value one year from now is calculated as below
  • Price= $3.18*(1+6%)/(10%-6%)= $84.27

d. Based on the above workings and values provided in the question, the required values are calculated as below:

1. The expected dividend yield during the first year= {(Expected dividend / Current Stock price)*100}= {($3.18/$79.5)*100}= 4%
2. The expected capital gain yield during the first year= {(Expected capital appreciation / Current Stock price)*100}= [{(Expected stock price one year from now - current stock price) / Current stock price}*100]= [{($84.27-$79.5)/$79.5}*100]= 6%
3. Total return= Dividend yield + Capital Gain Yield= 4% + 6% = 10%

e. Again, based on Gordon Growth model (as shared in 'b' above), if the stock price is selling at $79.5, the expected return is calculated as follows:

• Expected return= {(Expected dividend next year)/ Stock price} + Dividend growth rate = (3.18/79.5) + 6%= 10%

f. If the expected growth rate in dividend is zero, the dividend would stay at the current levels of $3 per share and the stock price can be calculated as below:

• Price = (Expected dividend next year / Cost of Equity)= ($3/10%) = $30