Question

Jessica's Pharmacy made two announcements concerning their common stock today. First, the company announced the next annual dividend will be $1.48 a share. Secondly, all dividends after that will increase by 2.5 percent annually. What is the maximum amount you should pay to purchase a share of this stock if your goal is to earn a 12 percent rate of return?

Answer 1

Step-by-step explanation:

Next year's dividend (D1) = 1.48

Perpetual growth rate (g) =2.5% or 0.025 as a decimal

Rate of return or discount rate = 12% or 0.12 as a decimal

Since the dividends will be growing at a constant rate with no definite time period, it means that it will grow at that rate forever.

Use present value of growing perpetuity formula to calculate the price of this stock;

Price = D1 /(r-g)

Price = 1.48 / (0.12 - 0.025)

= 1.48/ 0.095

= 15.5789

Therefore the maximum amount you should pay is $15.58