Question

A stock recently made a huge dividend payment of $20/share. They plan to reduce their dividend payments by $5/share in each of the next 2 years (i.e., they will pay $15/share in year 1 and $10/share in year 2). Afterwards, they will change to a constant dividend growth policy by increasing their dividend by 4%/year, indefinitely. The required return is 15%.  Calculate the stock price.

		90.90
		90.91
		81.78
		79.05
		None of the above.

Answer 1

Solution:
	Answer is 5th option None of the above.
Working Notes:
	The stock price (P0) = D1/(1+r) + D2/(1+r)^2 + P2/(1+r)^2
	r= required rate of return= 15%
	D1= $15
	D2= $10
	P2=$94.54545454
	The stock price today (P0) = D1/(1+r) + D2/(1+r)^2 + P2/(1+r)^2
	P0 = 15/(1.15) + 10/(1.15)^2 + 94.545454545/(1.15)^2
	P0=13.043478 + 7.56143667 + 71.4899467
	P0 = 92.09486
	P0 =92.09
	Since, the Stock price (P0) = $92.09
	Our answer is 5th option None of the above.
	calculation of terminal value at the end of 2nd year
	Using Gordon constant growth model : P2 = D2(1+g) / (r - g),
	P2= ??
	g= growth rate=4.0 %
	D2= $10 per share
	r= required rate of return= 15%
	P2= D2(1+g)/(r -g)
	=$10(1+0.04)/(0.15-0.04)
	=$10.40 /0.11
	=$94.54545454
Please feel free to ask if anything about above solution in comment section of the question.