Question

Microtech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Microtech to begin paying dividends, beginning with a dividend of $0.75 coming 3 years from today. The dividend should grow rapidly - at a rate of 26% per year - during Years 4 and 5; but after Year 5, growth should be a constant 6% per year. If the required return on Microtech is 16%, what is the value of the stock today? Round your answer to the nearest cent.

Answer 1

At the end of year 3 , Dividend = $0.75

The dividend should grow rapidly - at a rate of 26% per year - during Years 4 and 5

At the end of year 4 , Dividend = $0.75( 1+ 0.26) = 0.945

At the end of year 5 , Dividend = $0.945( 1+ 0.26) = 1.191

after Year 5, growth should be a constant 6% per year

At the end of year 6 , Dividend = $1.191( 1+ 0.06) = 1.262

Using the Dividend Gordon growth model,

Terminal value of the stock at the end of year 5 = D6 / (k-g)

Where, D6 = Dividend at end of year 6 = 1.262

k = rate of return = 16%

g= constant growth = 6%

Hence Terminal value of the stock at the end of year 5 = 1.262 / (0.16 - 0.06)

= 12.6246

We need to find the present value of the dividends and terminal value to calculate the stock value today

This is shown in the table below,

year	Cash flow(CF)	PV factor	CF* Pv factor
1	0	0.862069	0
2	0	0.743163	0
3	0.75	0.640658	0.480493255
4	0.945	0.552291	0.521915087
5	1.191	0.476113	0.567050601
5	12.6246	0.476113	6.010736374
Total	7.580195318

Hence the value of stock today is $ 7.58