Question

Stephens Supply Company (SSC) is growing rapidly. Assume Today’s stock price is $60. SSC currently pays no dividend but expects to pay its first dividend two years from today. SSC expects to maintain its current growth rate of 25% annually for the next three years (1 year after beginning to pay dividends), after which SSC expects the growth rate to decrease to 5% annually. If the appropriate discount rate is 12%, then what is the amount of the first dividend that SSC expects to pay?

Answer 1

Given about SSC,

Current stock price = $60

they are expected to pay 1st dividend 2 years from today.

Let dividend in year 2 be D

=> D2 = D

it will grow at 25% for next 3 years

=> D3 = 1.25D

D4 = 1.25*1.25D = 1.5625D

D5 = 1.25*1.5625D = 1.9531D

there after constant growth rate is 5%

discount rate r = 12%

So, price of stock at year 5 using constant dividend model is

P5 = D5*(1+g)/(r-g) = 1.9531D*1.05/(0.12-0.05) = 29.2969D

So, current stoack price of the stock is

P0 = D2/(1+r)^2 + D3/(1+r)^3 + D4/(1+r)^4 + D5/(1+r)^5 + P5/(1+r)^5

=> 60 = D/1.12^2 + 1.25D/1.12^3 + 1.5625D/1.12^4 + 1.9531D/1.12^5 + 29.2969D/1.12^5

=> 60 = D*20.6238

=> D = $2.94

So, amount of 1st dividend that SSC expects to pay is $2.94