Question

Magnetic Corporation expects dividends to grow at a rate of 17% for the next two years. After two years dividends are expected to grow at a constant rate of 6.1%, indefinitely. Magnetic’s required rate of return is 11.2% and they paid a $1.65 dividend today. What is the value of Magnetic Corporation’s common stock per share? (Show your answers to the nearest cent) What is

Dividend at end of year 1:

What is Dividend at end of year 2:

What is Dividend at end of year 3:

What is Price of stock at end of year 2:

What is Price of stock today:

Answer 1

This question requires an application of dividend discount model. According to the dividend discount model, current stock price is the present value of all dividends (discounted at required rate of return) expected to be paid in future by company.

But, to apply this model, we first need to calculate the expected dividend. Growth rate for dividends for year 1 and year 2 is given as 17%, and 6.1% thereafter from year 3 onwards.

Dividend today, D₀ = $1.65

Dividend at year 1, D₁ = $1.65 * (1 + 17%) = $1.930

Dividend at year 2, D₂ = $1.93 * (1 + 17%) = $2.259

Dividend at year 3, D₃ = $2.26 * (1 + 6.1%) = $2.396

According to dividend discount model:

where, Vn is the terminal value of dividends, when growth rate becomes constant

So, applying this model to our question,

V₂ = 46.989

P₀ = 1.736 + 1.827 + 38.001

P₀ = $41.563. Price of Stock today

Price of stock at the end of year 2 is basically the terminal value calculated above (since growth is becoming constant from year 3 onwards).

V₂ = $46.989. Price of stock at end of year 2.