Question

Tan Rocks, an outdoor theater, has suspended their dividend to conserve capital for the rest of their fiscal year (May 1 to May 1) since they do not anticipate being open this summer. Management is assuming the Covid19 effects will continue for each of the next two seasons as well before returning to normal. As such they estimate next year’s dividend to be $1 per share (2021) and it will increase to $1.50 a share the following year (2022). The dividend will return to $2.50 a share in 2023. If the dividend’s historical growth of 3 percent a year returns to normal after 2023 and the required rate of return on the stock of Tan Rocks is 10 percent, what should be their current stock value be based on these assumptions and projections?

Please explain work clearly, thanks

Answer 1

Current Stock Price = Present Value of all future dividends (calculated at required rate of return of 10%)

Current Stock Price = $31.66 per share

Workings:

Notes:

1. Discount factor for required rate of return of 10% calculated using the formula 1/(1+r)^t where r = rate of return; t = period

2.. Perpetual growth after 2023 is calculated using Dividend Growth model using the following formula:

P = D1/(r-g) where P = price of the share; D1 = Dividend next year; r = rate of return; g = growth rate

After 2023, since dividend grows at 3%, dividend of 2024 (D1) is 2.5 *(1+3%) = $2.575.

Thus, price of growing perpetual dividend at 2023 = $2.575/(10%-3%) = $36.79