Question

Assume that Bon Temps’ earnings and dividends are expected to decline by a constant 4% per year—that is, g = -4%. Why might someone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year? Assume that the required rate of return is 16%. The dividend paid yesterday was $2.00.

**SHOW ALL WORK PLEASE**

Answer 1

As per the Gordon growth model or the dividend discount model,

Price of a share = Next year's dividend / (required rate of return - growth rate in perpetuity for the dividends)

In the given question,

Growth rate for the dividends = - 4%

Required rate of return = 16%

Next years dividend will be $2 * (100% - 4%) = $2 * 96% = $1.92

The price of the stock as per the dividend discount model = 1.92 / (16% - (-4%))

=1.92 / (16% + 4%) = 1.92 / 20%

= $ 9.6

The price of stock of Bon Temps should be $9.6

Investment in the stock may be done due to the high value of dividends in relation of the current price of the stock in the initial years. The present value of the returns of the initial years will be higher and thus, an investor looking for higher cashflow in the inital years may invest in the stock based on its low price due to the negative expected growth rate in the dividends.