Question

Stock in Canacorp will pay a dividend of $1.23 at the end of one period, $2.45 at the end of two periods, and then dividends will grow at a constant rate of 6.25% per year indefinitely. If the required return is 11% we can value Canacorp stock by finding P2 using D3, then finding P0 = D1/(1.11) + D2/(1.11)2 + P2/(1.11)2. In this formula it almost appears as if we are ignoring all dividends from year three on. Discuss.

Answer 1

D1	1.23
D2	2.45
Find the price of the stock in year 3
g	0.0625
D3	2.45*(1+.0625)
D3	2.603125
According to the dividend growth model.
P2 = D3/(R-g)
R	11%
P2	2.603125/(.11 - .0625)
P2	54.80263158
Cash flow in year 2	P2+D2
Cash flow in year 2	57.25263158
The price of the stock today = sum of present value of future cash flows.
Using R = .11
Year	1	2
Cash flow	1.23	57.25263
Present value	1.11	46.47
sum of present values	47.58
The value of the Canacorp stock is $47.58.
The dividends from year 3 on are not being ignored. The price of the stock
in year 2 according to the dividend growth model is D3(dividend in year 3)/(R-g)
where R is the required return on the stock and g is the constant growth rate
of the dividend indefinitely starting from year 3.