Question

DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have been declared as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its fast growth. After that, dividends are expected to grow at a constant growth rate of 6 percent. The firm's required rate of return is 18 percent. Is the stock overpriced or underpriced? By how much?

SHOW ALL CALCULATIONS AND FORMULA IN EXCEL ONLY

Answer 1

We need to use dividend growth model for the same:

Dividend in year 1 and 2 shall be zero as no dividends are paid

YEar 4 dividend =$2.00*1.06=$2.12

Year	Div	Terminal value	Total		Discount factor		Present Value
1	$          -		$          -		0.847457627		$                      -
2	$          -		$          -		0.71818443		$                      -
3	$ 2.0000	$                17.67	$   19.67		0.608630873		$               11.97
4	$      2.12					Total	$          11.9697

Discount factors (DF)are calculated as:1/(1+r)^n

Where r is required return and n is the year

For the perpetual growth period, terminal value (TV) of dividends = Dividend next period/(r-g) where r is the required return and g is the growth rate.

Terminal value of dividends= 2.12/(0.18-0.06)=$17.67

As we can see that the stock valued on dividend basis is worth less than $15, hence it is overpriced

Answer 2

Overpriced and $3.03