Question

Suppose a firm's dividends are expected to grow at a rate of 15% (g1) for 3 years (t) then stabilize at 5% (g2) forever. If the firm just paid a $2.00 (D0) dividend and the discount rate is 10% (r), what is the value of a share of the firm's stock in year 3 (P3 )? (Do not round your intermediate calculation.)

Answer 1

The answer is: $63.88

Step-by-step explanation:

First we calculate the dividends paid at year 3 will be:

- dividends year 3 = $2 x (1 + g1)³ = $2 x 1.15³ = $2 x 1.52 = $3.04

Then we calculate the dividends paid at year 4 will be:

- dividends year 4 = $3.04 x (1 + g2) = $3.04 x 1.05 = $3.19

Finally, to calculate the value of the stock at year 3 we can use the perpetuity formula:

Price at year 3 = D4 / (r -g2)

• D4 = $3.19
• r = 10%
• g2 = 5%

P3 = $3.19 / (10% - 5%) = $3.19 / 5% = $63.88