Question

Check My Wor eBook Problem Walk-Through Computech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Computech to begin paying dividends, beginning with a dividend of $1.00 coming 3 years from today. The dividend should grow rapidly at a rate of 15% pe year during Years 4 and 5, but after Year 5, growth should be a constant 8% per year. If the required return on Computech is 14%, what is the value of the stock today? Do not round intermediate calculations, Round your answer to the nearest cent.

Answer 1

Required Return (ke)=   14%
  
3rd year dividend D3=   1
growth is 15% for next 2 years. D4= D3*(1+g)  
1*(1+15%)=   1.15
D5= 1.15*(1+15%)=   1.3225
From 5th year onwards Constant Growth Rate (g)=   8%
D6= 1.3225*(1+8%)=   1.4283
  
When Constant Growth arises. price of Stock is calculated using Constant Growth model formula.  
Constant Growth formula:  
Price of stock at end of Year (P5) = D6/(Ke -g)  
1.4283/(14%-8%)  
23.805  
  
Now value of stock today will be present value of Dividend received upto 5 year and price of Stock at end of 5th year (P5)  
  
Formula for Current price of stock = D1/(1+ke)^1 + D2/(1+ke)^2 + D3/(1+ke)^3 + D4/(1+ke)^4 + D5/(1+ke)^5 + P5/(1+ke)^5  
0+0+(1/(1+14%)^3) + (1.15/(1+14%)^4) + (1.3225/(1+14%)^5) + (23.805/(1+14%)^5  
14.40629995  
  
So current value of stock is   $14.41