Question

The company currently pays irregular dividends in the next four years: D1=$2, D2=$2.5, D3=$5.2, D4=$8.5. Investors believe that the dividends are expected to grow at 2% thereafter. The required rate of return on the stock is 8%.

a.What is the current market price of the stock?

b.What would be the stock price in 10 years?

Answer 1

a) The problem can be solved by using Constant Dividend growth model.

We will have to find the present value of all the future dividends, then the present value of the terminal cashflow.

Terminal cash flow at the end of year 4, will be found by using constant dividend growth model, as the dividend will increase by 2% thereafter, so the formula for terminal cashflow is

= (Year 4 dividend) * (1 + Constant growth rate) / (Required return on stock - constant growth rate)

= 8.5 * (1 + 2%) / (8% - 2%)

= 144.5

Current Market price = Present value of D1 + Present value of D2 + Present value of D3 + Present value of D4 + Present value of Terminal Cash flow

= 2 / (1 + 8%) + 2.5 / (1 + 8%)^2 + 5.2 / (1 + 8%)^3 + 8.5 / (1 + 8%)^4 + 144.5 / (1 + 8%)^4

= 120.5826

So the current market price of stock is 120.5826

b) If you need to find the stock price after year 10, then you need to find the future value of the stock price with compounding rate of 8%

Future value of stock price = Current Stock Price ( 1 + Required return on stock)^n

= 120.5826 ( 1 + 8%)^10

= 260.5826

So the stock price at the end of 10 years will be 260.5826