Question

ABC Company last paid a $3.00 per share annual dividend. The company is planning on paying $3.5.00, $4.5.00, $5.5.00, and $6.5.00 a share over the next four years, respectively. After that the dividend will be a constant $4.50 per share per year. Answer the following questions:

a. What is the price of the stock today if investors require a 12 percent rate of return?

b. What is the price of the stock today if the sustained dividend of the company is $5.50 a share instead of $4.50, and investors require a 9 percent rate of return?

c. How could constant growth model be modified to become more useful to price shares of common stock?

Answer 1

a) Horizon value of the firm after 4 years (when 0 growth starts)

= Revenue from 5th year onwards/ required rate of return

=$4.5/0.12

=$37.50

So, price of the stock today

=3.5/1.12+4.5/1.12^2+5.5/1.12^3+6.5/1.12^4+37.5/1.12^4

=$38.59

So, price of the stock today is $38.59

b) if the sustained dividend of the company is $5.50 a share instead of $4.50, and investors require a 9 percent rate of return

Horizon value of the firm after 4 years (when 0 growth starts)

= Revenue from 5th year onwards/ required rate of return

=$5.5/0.09

=$61.11

So, price of the stock today

=3.5/1.09+4.5/1.09^2+5.5/1.09^3+6.5/1.09^4+61.11/1.09^4

=$59.14

So, price of the stock today will be $59.14

c) Constant growth model should be modified and an explicit forecast period (as long as possible) should be selected and cashflows to firm or equity be projected for every year in this period. The constant growth assumptions should be taken at a future point of time (as distant as possible) so that the error in estimation due to a wrong constant growth figure is minimised.