Question

What are the benefits and issues related to stock ownership as an investment type? What are the issues related to equity as a source of additional funds, and valuation concepts?

Problem 13) Stock ABC is expected to pay dividends of $1.20 and $1.50 respectively, in one and two years. After that, stock ABC is entering a constant growth stage. Then stock ABC is expected to grow with the constant growth rate of 4%. If the required rate of return on ABC is 12% what is the price of ABC?

Must show work to receive all 20 points!

Answer 1

Step-1, Dividend for the next 2 years

Dividend in Year 1 (D1) = $1.20 per share

Dividend in Year 2 (D2) = $1.50 per share

Step-2, The Price of the stock in year 2 (P2)

Dividend Growth Rate after 2 years (g) = 4% per year

Required Rate of Return (Ke) = 12%

Therefore, the Share Price in year 2(P2) = D2(1 + g) / (Ke – g)

= $1.50(1 + 0.04) / (0.12 – 0.04)

= $1.56 / 0.08

= $19.50 per share

Step-3, Current Price per share

As per Dividend Discount Model, The Current Price per share is the aggregate of the Present Value of the future dividend payments and the present value the share price in year 2

Year	Cash flow ($)	Present Value factor at 12%	Present Value of cash flows ($)
1	1.20	0.89286	1.07
2	1.50	0.79719	1.20
2	19.50	0.79719	15.54
TOTAL			17.81

“Therefore, the Price of ABC Stock will be $17.81 per share”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.