Question

Microweb Company has never paid a dividend. But, this year the company expects to pay a dividend equal to $2.50 per share, and it plans to continue paying this same dividend for the following two years (a total of three years). After the $2.50 dividend is paid at the end of Year 3 (i.e., beginning in Year 4), the company expects the dividend to grow at a 3 percent rate, and this growth rate will continue indefinitely. If investors require a 14 percent rate of return to purchase the company's common stock, what should be the market value of Microweb's stock today?

Answer 1

To calculate the market value of Microweb's stock today, we use the present value of expected dividends for the first three years and the Gordon Growth Model for the perpetuity starting in Year 4. We then discount the calculated future values to the present considering a 14 percent rate of return required by investors.

Step-by-step explanation:

To determine the market value of Microweb's stock today, we need to calculate the present value of expected future dividends. Given that Microweb plans to pay a $2.50 dividend per share for the next three years and then increase this dividend by 3 percent annually starting in Year 4 indefinitely, we can use the Gordon Growth Model (also known as the Dividend Discount Model) to value the stock. This model is based on the idea that the value of a stock is the present value of all expected future dividends, discounted back to their value today.

We first calculate the present value of the dividends in Years 1, 2, and 3 using the formula for present value: PV = D / (1+r)^t, where PV is the present value, D is the dividend, r is the required rate of return (14% in this case), and t is the time in years. The sum of these present values is the value of the dividends that investors expect to receive in the first three years.

After Year 3, we treat the stock as a perpetuity that pays a growing dividend. The value of this perpetuity is calculated using the Gordon Growth Model, which is: P = D / (r - g), where P is the price of the stock at the beginning of Year 4, D is the dividend at Year 4, r is the required rate of return, and g is the growth rate of the dividend. We then discount this perpetual value back to the present to account for the time value of money.

Finally, the value of the stock today is the sum of these two parts: the value from the first three years and the discounted perpetual value from Year 4 onward. This gives investors an indication of what the stock should be worth in the market today, based on the required rate of return and the expected future dividends.