Question

Holyrood Co. just paid a dividend of $1.55 per share. The company will increase its dividend by 24% next year and will then reduce its dividend growth rate by 6 percentage points per year until it reaches the industry average of 6% dividend growth, after which the company will keep a constant growth rate forever. If the required return on Holyrood stock is 16%, what will a share of stock sell for today? (Do not round intermediate calculations. Round the final answer to 2 decimal places.

Answer 1

Step-1, Dividend for the next 3 years

Dividend in Year 0 (D0) = $1.55 per share

Dividend in Year 1 (D1) = $1.9220 per share [$1.55 x 124%]

Dividend in Year 2 (D2) = $2.2680 per share [$1.9220 x 118%]

Dividend in Year 3 (D3) = $2.5401 per share [$2.2680 x 112%]

Step-2, The Price of the stock in year 3 (P3)

Dividend Growth Rate after 3 years (g) = 6.00% per year

Required Rate of Return (Ke) = 16.00%

Therefore, the Share Price in year 3 (P3) = D3(1 + g) / (Ke – g)

= $2.5401(1 + 0.06) / (0.16 – 0.06)

= $2.6925 / 0.10

= $26.93 per share

Step-3, Selling price per share

As per Dividend Discount Model, the selling price of the stock is the aggregate of the Present Value of the future dividend payments and the present value the share price in year 3

Year	Cash flow ($)	Present Value factor at 16.00%	Present Value of cash flows ($)
1	1.9220	0.86207	1.66
2	2.2680	0.74316	1.69
3	2.5401	0.64066	1.63
3	26.93	0.64066	17.25
TOTAL			22.22

“Hence, the selling price of the stock today will be $22.22”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.