Question

The last dividend paid by Abbot Labs was $1. Abbot's growth rate is expected to be a constant 8% for 3 years, after which the growth rate is expected to be 10%. Investors require a return of 16% on stocks like Abbot. What should the price of Abbot's stock be?

Answer 1

The price of Abbot's stock should be $12.50 for the first three years and $18.33 thereafter, based on the Gordon Growth Model.

Step-by-step explanation:

To calculate the price of Abbot's stock, we need to use the Gordon Growth Model, which is used to value a stock based on its expected future dividends. The formula for the Gordon Growth Model is: Stock Price = Dividend / (Required Return - Growth Rate). In this case, the dividend is $1, the required return is 16%, and the growth rate is 8% for the first 3 years and 10% thereafter.

For the first three years, the stock price can be calculated as: Stock Price = $1 / (0.16 - 0.08) = $1 / 0.08 = $12.50. After the third year, the growth rate increases to 10%, so the stock price can be calculated as: Stock Price = $1 * (1 + 0.10) / (0.16 - 0.10) = $1.10 / 0.06 = $18.33.

Therefore, the price of Abbot's stock should be $12.50 for the first three years and $18.33 thereafter.