Question

IGM Financial has paid a dividend of $2.25 per year for the last five years, however, due to COVID, investors think dividends will be reduced. Investors think dividends for the next two years will be $1 and will then resume at $2.25 per year and will grow at 2% indefinitely after that. If investors are right, what is the value of a share of IGM? Assume a discount rate of 7%.

Select one: a. $37.05 b. $41.11 c. $45.00 d. $47.00

Answer 1

According to Dividend Discount model, the value of shares presently is given by present value of all dividends. We need to discount all future dividends to get value today. According to constant growth model, the price of share today for dividends growing at a constant rate forever is given by Po = D1/(r-g) where Po is price today, D1 is dividends next year, r is discount rate and g is constant growth rate.

Past dividends would not matter.

Po = D1/(1+r) + D2/(1+r)^2 + D3/(1+r)^3 ... Till forever

We are discounting all future cash flows. Now, from year 4 dividends start growing at constant rate.

Therefore, the price of all dividends from year 3 till forever at time 2 = P2. According to growth model, this is equal to

P2 = D3/(r-g)

P2 = 2.25/(0.07-0.02) = 45

We need to discount it to present.

So, Po = D1/(1+r) + D2/(1+r)^2 + P2/(1+r)^2

Po = 1/(1.07) + (1/1.07^2) + 45/(1.07^2)

Po = $41.11

Thus the correct option is b. $41.11

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