Question

In: Finance

(1) Suppose a company just paid a dividend of $3.6. Its manager promises to pay annual...

  1. (1) Suppose a company just paid a dividend of $3.6. Its manager promises to pay annual dividend growing at 6% per year. If the required return is 12% (in EAR), what would the current price be?
    (2) Now assume the manager has decided to pay quarterly dividends instead of annual dividends. It has just paid a dividend of $0.9. The next dividend will be 3 months from now, with value equal to $0.9*1.061/4, and will grow at an annual rate of 6%. That is, each dividend payment will be 1.061/4 times the previous one. What is the share price now?
    (3) Now assume the dividend will grow more slowly at a rate of 2% per year from the 40th quarterly dividend. That is, the 41st dividend will be equal to the 40th dividend multiplied by 1.021/4. What is the share price now?

Solutions

Expert Solution

(1) Suppose a company just paid a dividend of $3.6. Its manager promises to pay annual dividend growing at 6% per year. If the required return is 12% (in EAR), what would the current price be?

D0 = $ 3.6; g = 6%; D1 = D0 x (1 + g) = 3.6 x (1 + 6%) = 3.816

Required return, Ke = 12%

Hence, Current Price = D1 / (Ke - g) = 3.816 / (12% - 6%) = $  63.60

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(2) Now assume the manager has decided to pay quarterly dividends instead of annual dividends. It has just paid a dividend of $0.9. The next dividend will be 3 months from now, with value equal to $0.9*(1.06)^1/4, and will grow at an annual rate of 6%. That is, each dividend payment will be 1.06^(1/4) times the previous one. What is the share price now?

Frequency = Quarterly

Period = quarter

Expected divided next period = D1 = $ 0.9 x (1.06)1/4 = $ 0.913206462

Growth rate per period, g = growth rate per quarter = 1.061/4 - 1 = 1.47%
Required return per period = Required return per quarter = Effective quarterly rate = Ke = (1 + EAR)1/4 - 1 = (1 + 12%)1/4 - 1 = 2.87%

Hence, Current Price = D1 / (Ke - g) = 0.913206462 / (2.87% - 1.47%) = $  64.93

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(3) Now assume the dividend will grow more slowly at a rate of 2% per year from the 40th quarterly dividend. That is, the 41st dividend will be equal to the 40th dividend multiplied by (1.02)^1/4. What is the share price now?

This has now become a two stage model,

First stage growth rage, g1 = 1.061/4 - 1 = 1.47%

Second stage growth rate, g2 = 1.021/4 - 1 = 0.50%

D41 = D40 x (1 + g2)

D40 = D0 x (1 + g1)40 = 0.9 x 1.06(40/4) x 1.021/4 = 1.619761996

Horizon value of future dividends at the end of 40th quarter, DHV, 40 = D41 / (Ke - g2) = 1.619761996 / (2.87% - 0.50%) = 68.13047228

Current price = PV of annuity D1 growing at g1 over (n =) 40 periods + PV of DHV, 40

=$  49.43


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