Question

1. Coral corporation just paid a dividend of $4.25 a share. The company will increase its dividend by 20% next year and will then reduce its dividend growth rate by 5% a year (example year 2 dividend growth rate is 20% - 5% = 15%) until it reaches the industry average of 5 percent dividend growth after which the company will keep the constant growth rate of 5%.
   1. If the required rate of return on Coral corp stock is 11%, what will be the share price according to the Dividend discount model?

If the share price is 63.82$ and all the dividend information remains the same, what is the required rate of return of Coral Stock?

Answer 1

Solution a.

We have to use a multi-stage Dividend Discount Model.

Firstly, calculate the dividends for each year. Since the Dividend rate is getting constant from year 4, we will calculate the terminal value, which will be added back to the dividend of year 3 to get the final cash flows. These final cash flows will be discounted at the rate of 11% to get the desired PV of cash Flows. Adding all the PV, will given us the desired answer.

Year	0	1	2	3	4
Dividends	4.25	5.1	5.865	6.4515	6.774075
		=1.2*4.25	=5.1*1.15	=5.865*1.1	=6.4515*1.05
Terminal Value				112.90125
				=6.774075/(0.11-0.05)
Final Cash Flows		5.1	5.865	119.35275
PV of cash Flows		4.594594595	4.760165571	87.26970213
		=5.1/(1.11)^1	=5.865/(1.11)^2	=87.26970213/(1.11)^3
Sum of PV					$96.6244623

Solution b.

At the rate of 14.04%, we will get the share price of $63.8

Year	0	1	2	3	4
Dividends	4.25	5.1	5.865	6.4515	6.774075
		=1.2*4.25	=5.1*1.15	=5.865*1.1	=6.4515*1.05
Terminal Value				74.93445796
				=6.774075/(0.1404-0.05)
Final Cash Flows		5.1	5.865	81.38595796
PV of cash Flows		4.472115047	4.509761754	54.87541958
		=5.1/(1.1404)^1	=5.865/(1.1404)^2	=81.38595796/(1.1404)^3
Sum of PV					63.85729638
					=SUM(L22:N22)

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