Question

Corporate Financial Management:The Equity Markets

10. a. XYZ Plc is growing quickly. Dividends are expected to grow at a 30 per cent rate for the next three years, with the growth rate falling off to a constant 6 per cent thereafter. If the required return is 13 per cent and the company just paid a €1.80 dividend, what is the current share price?

2. XYZ Corp will pay a €4 dividend next year on its common stock, which is currently selling at €100 per share. What is the required rate of return on this investment if the dividend is expected to grow at 5% forever?

3. Sometimes, a supernormal growth pattern is observed in stock prices. How is the supernormal growth pattern likely to vary from the normal, constant growth pattern? What kind of firms tend to experience the supernormal growth pattern?

Answer 1

a.] Stock price = D1 / (1+required rate) + D2 / (1+required rate) ² + D2 / (1+required rate) ³ + D4 / (required rate - growth rate) * (1+required rate) ^-3

= 2.34 / (1+0.13) + 3.042 / (1+0.13)²  + 3.955/ (1+0.13)³    + 4.192 /(0.13 - 0.06) * (1+0.13)^-3

= 2.34 / (1.13) + 3.042 / (1.13)²  + 3.955/ (1.13)³    + 4.192 / 0.07 * (1.13)^-3

= 2.34 / 1.13 + 3.042 / 1.2769 + 3.955 / 1.4429      + 4.192 / 0.07 * 1/(1.13)³

= 2.34 / 1.13 + 3.042 / 1.2769 + 3.955 / 1.4429      + 4.192 / 0.07 * 1/1.4429

= 2.0708 + 2.3823 + 2.7410     + 41.5037

= 48.70

Note:- D1 =1.8 * 1.30 = 2.34

D2 = 2.34 * 1.3 = 3.042

D3 = 3.042 * 1.3 = 3.955

D4 = 3.955 * 1.06 = 4.192

b.] Stock price = next year dividend / (required rate - growth rate)

100 = 4 / ( required rate - 0.05)

100 required rate - 5 = 4

   100 required rate = 9

   required rate of return = 9%