Question

Darla Davidovics would like to purchase the stock of Dalmation Dolls Inc. The company plans to pay a dividend of $4.18 next year which will grow by 5.2% in the second year of the holding period. The dividend is expected to grow by 7.5% in the third year of the holding period and Darla expects to sell the stock at the end of that year for $85. If Darla’s expected rate of return on this stock is 21%, what is the maximum she would pay if she purchases the stock today ?

Answer 1

Dividend in Year 1, D1 = $4.18

Growth Rate for Year 2 = 5.20%
Growth Rate for Year 3 = 7.50%

Dividend in Year 2, D2 = $4.18 * 1.0520
Dividend in Year 2, D2 = $4.39736

Dividend in Year 3, D3 = $4.39736 * 1.0750
Dividend in Year 3, D3 = $4.727162

Stock Price in Year 3, P3 = $85.00

Required Return, rs = 21%

Current Stock Price, P0 = D1/(1+rs) + D2/(1+rs)^2 + D3/(1+rs)^3 + P3/(1+rs)^3
Current Stock Price, P0 = $4.18/1.21 + $4.39736/1.21^2 + $4.727162/1.21^3 + $85.00/1.21^3
Current Stock Price, P0 = $57.11