Question

Gutierrez & Ravenna Company has just paid a dividend of D0 = $2.00. Due to a new product, Gutierrez & Ravenna expects its short-run growth rate in dividends to equal 20 percent annually for the next 3 years. After this time, growth is expected to return to the long-run constant rate of 5 percent. The required rate of return on the company’s equity is 12%. What should the dividend yield (D1/P0) be today? [Hint: Find the price (P0) today prior to computing the dividend yield (D1/P0)]

a. 5.48%

b. 5.05%

c. 4.57%

d. 6.06%

e. None of the above

Please choose the MOST correct alternative.

a. If the discount rate used for a project with normal cash flows is equal to its IRR, then the PI = 1.

b. The NPV of a project is equal to zero when the discount rate used is the IRR.

c. For a project with normal cash flows, the PI will always be greater than 1 if the NPV is positive.

d. The decision regarding acceptance / rejection of a project should be based on the NPV criterion.

e. All of the above are correct.

Answer 1

Step-1, Calculation of Dividend per share for the next 3 years

Dividend in Year 0 (D0) = 2.00 per share

Dividend in Year 1 (D1) = $2.40 per share [$2.00 x 120%]

Dividend in Year 2 (D2) = $2.88 per share [$2.40 x 120%]

Dividend in Year 3 (D3) = $3.4560 per share [$2.88 x 120%]

Step-2, Calculation of Stock Price for the Year 3 (P3)

Here, we have Dividend per share in year 3 (D3) = $3.4560 per share

Dividend Growth Rate (g) = 5.00% per year

Required Rate of Return (Ke) = 12.00%

Stock Price for the Year 3 = D3(1 + g) / (Ke – g)

= $3.4560(1 + 0.05) / (0.12 – 0.05)

= $3.6288 / 0.07

= $51.84 per share

Step-3, Current price of the stock (P0)

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

Year	Cash flow ($)	Present Value factor at 12.00%	Present Value of cash flows ($)
1	2.4000	0.892857	2.14
2	2.8800	0.797194	2.30
3	3.4560	0.711780	2.46
3	51.84	0.711780	36.90
\TOTAL			43.80

The Dividend Yield (D1 / P0)

Therefore, the Dividend Yield (D1 / P0) = [Dividend in Year 1 / Current stock price] x 100

= [$2.40 / $43.80] x 100

= 5.48%

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.

The correct alternative will be “(e).All of the above are correct”.