Question

Percentages need to be entered in decimal format, for instance 3% would be entered as .03.

1. Microweb Company has never paid a dividend.  But, this year, the company expects to pay a dividend equal to $2.50 per share, and it plans to continue paying this same dividend for the following two years (a total of three years).  After the $2.50 dividend is paid at the end of Year 3 (i.e. beginning in Year 4), the company expects the dividend to grow at a normal (constant) 3% growth rate , and this growth rate will continue indefinitely (there is no noncontact growth expected).  If investors require a 14% rate of return to purchase the company's common stock, what should be the market value of Microweb's stock today (current price)?  What would the market value (price) be at the end of Year 3?

Answer 1

Equal Dividend between Year 1 and Year 3 = $ 2.5

 

Required Rate of Return = 14%, Perpetual Rate of Growth = 3%

 

Year 4 Dividend = 1.03 x 2.5 

                             = $ 2.575

 

Horizon Value (present value at the end of Year 3) of Perpetual Growth Dividends = 2.575 / (0.14-0.03) 

                                                                                                                                                  = $ 23.40909091

 

Present Value of Horizon Value = P1 = 23.40909091 / (1.14)^(3) 

                                                                 = $ 15.80046958

 

Present Value of Equal Dividends = P2 = 2.5 x (1/0.14) x [1-{1/(1.14)^(3)}] 

                                                                     = $ 5.80408

 

Current Value of Stock = P1 + P2 = 15.80046958 + 5.80408 

                                                              = $ 21.6045 ~ $ 21.6

Present Value of Horizon Value = $ 15.80046958

 

Present Value of Equal Dividends = $ 5.80408

 

Current Value of Stock = P1 + P2 = $ 21.6