Question

You are a financial executive at Dunder Mifflin. Your boss, David Wallace, wants you to estimate the price of the company’s stock. Currently, the company does not pay dividends. However, in 3 years the company expects to pay its first dividend of $0.50, After that, dividends will grow at 80% per year for 2 years. Then, dividends will grow at a constant rate of 7% per year indefinitely

If the company’s cost of equity is 16% and the market is in equilibrium, what is the price of the stock today?

Answer 1

Step 1: Computation of market price at the end of year 5 using Gordon Growth Model

P5 = D6 / (Ke – g)

Where,

P5 - Market price at the end of year 5 = ?

D6 - Expected dividend in year 6 = .5*1.8^2*1.07 = 1.7334

Ke – Cost of equity = 16%

G – Growth rate in dividend = 7%

P5 = 1.7334/(.16-.07)

= 1.7334/.09

= $19.26

Step 2: Computing current share price by discounting the cash flow at required return

Year	Dividend	PVF@16%	Present Value (Cashflow*PVF)
3	0.50	0.641	0.32
4	0.90	0.552	0.50
5	20.88	0.476	9.94

Current share price = Cashflow*PVF

= .32+.50+9.94

= $10.76