Question

Flash Inc. was founded 5 years ago. It has been profitable for the last 2 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $1 dividend starting one year from today, then it will increase the dividend growth by 50% for the next two years, and then the company will achieve a long run growth rate of 6%. Assuming a required return of 11%, what is your estimate of the stock's intrinsic value today? a) Calculate the Flash Inc. non-constant dividends. b) Calculate the Flash Inc. horizon value. c) What is the firm's intrinsic value today, P̂ 0?

Answer 1

According to Dividend discount model, the price of stock today is equal to present value of all future dividends.

According to constant growth model, the price of stock today whose dividends grow at a constant rate of g% is as under

P0 = D1/(r-g) where P0 is stock price today, D1 is dividend bext year, constant growth in dividends is g and discount rate is r.

When stable growth rate is assumed, then terminal value or horizon value is the present value of all future cash flows but at a future time period.

a. Dividend next year = D1= $1

Dividend in year 2 = D2 = 1*(1+0.5) = $1.5

Dividend in year 3 = D3 = D2*(1+0.5) = 1.5*1.5 = $2.25

b. Dividend in year 4 = D4 = D3*(1+0.06) = 2.25*1.06 = $2.385

Thus, value of stock at time 3 according to constant growth model is , P3 = D4/(r-g)

Here, required rate is r which is 11%, g is 6%

Thus, horizon value = P3= 2.385/(0.11-0.06) = $47.7.

c. Intrinsic value today is present value of all future dividends. P3 is present value of all future dividends starting from year 4 onwards. Discounting of P3 to P0 needs to be done and added go present value of D1,D2 and D3 to get intrinsic value today.

P0 = D1/(1+r) + D2/(1+r)^2 + D3/(1+r)^3 + P3/(1+r)^3

= 1/1.11 + 1.5/1.11^2 + 2.25/(1.11^3) + 47.7/(1.11^3)

Thus, P0 = 0.9009+1.2174+1.6451+34.8778

P0 = 38.6412

Thus, intrinsic price of stock today is $ 38.64.

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