Question

2. You are considering the purchase of a common stock that paid a dividend of $2.00 yesterday. You expect this stock to have a growth rate of 15 percent for the next 3 years, resulting in dividends of D1 $2.30, D2 $2.645, and D3 $3.04. The long-run normal growth rate after year 3 is expected to be 10 percent (that is, a constant growth rate after year 3 of 10% per year forever). If you require a 14 percent rate of return, how much should you be willing to pay for this stock? A) $89.75 B) $83.65 C) $56.46 D) $62.57

Answer 1

Value after year 3=(D3*Growth rate)/(Required rate-Growth rate)

=(3.04*1.1)/(0.14-0.1)

=83.6

Hence current value=Future dividend and value*Present value of discounting factor(rate%,time period)

=2.3/1.14+2.645/1.14^2+3.04/1.14^3+83.6/1.14^3

=$62.57(Approx).