Question

Phoenix Industries has pulled off a miraculous recovery. Four years ago it was near bankruptcy. Today, it announced a $3 per share dividend to be paid a year from now, the first dividend since the crisis. Analysts expect dividends to increase by $1 a year for another 2 years. After the third year (in which dividends are $5 per share) dividend growth is expected to settle down to a more moderate long-term growth rate of 6%. If the firm’s investors expect to earn a return of 14% on this stock, what must be its price?

Answer 1

Sol:

Dividend to be paid 1 year from now = $3 per share

Dividend is expected to grow by $1 in for another 2 years.

Dividend to be paid 2 year from now = $4 per share

Dividend to be paid 3 year from now = $5 per share

After 3rd year dividend growth is expected to settle down to a more moderate long-term growth rate of 6%. We have to find stock price after growth is settling down and then we need to discount it to get the present value (PV) of the share.

Dividend growth rate (dr) = 6%

Rate of return (r) = 14%

Dividend (d) = $5

Stock price 3 years from now = d x (1+dr) / (r-dr)

Stock price 3 years from now = 5 x (1+6%) / (14% - 6%)

Stock price 3 years from now = 5 x 1.06 / (0.14 - 0.06)

Stock price 3 years from now = 5.30 / 0.08

Stock price 3 years from now = $66.25

Now discounting stock price 3 years from now to PV:

$66.25 / (1+14%)^3

$66.25 / (1.14)^3 = $44.72

Therefore share price will be $44.72