Question

The Canning Company has been hard hit by increased competition. Analysts predict that earnings (and dividends) will decline at a rate of 5 percent annually into the foreseeable future. If Canning's last dividend (D0) was $2.00, and investors' required rate of return is 17 percent, what will be Canning's stock price in 3 years?

Answer 1

$14.25

Explanation:

We can use DDM (Dividend Discount Model) to answer this.

Firstly we have:

`D_1=D_(0)(1+g)`

Where D_1 is the dividend next year

D_0 is current divident

g is the growth rate (or decline rate)

We need to find until D_3 since we want stock price in 3 years.

So,

we know D_0 = 2

g = -0.05

Now, we have:

`D_1=D_(0)(1+g)\\D_1=2(1-0.05)\\D_1=2(0.95)\\D_1=1.9`

Now calculating D_2:

`D_2=D_(1)(1+g)\\D_2=1.9(0.95)\\D_2=1.805`

Calculating D_3:

`D_3=D_(2)(1+g)\\D_3=1.805(0.95)\\D_3=1.7 1`

The stock price follows the formula:

`Value=(D_3)/(r-g)`

Where D_3 is dividend in 3 years [1.71]

r is the required rate of return [17%]

g is the growth rate [-0.05]

Now, we have:

`Value=(D_3)/(r-g)\\Value=(1.71)/(0.17-0.05)\\Value=14.25`

Thus, $14.25 in 3 years