Question

Assume Highline Company has just paid an annual dividend of $1.06. Analysts are predicting a 10.7% per year growth rate in earnings over the next five years. After that, Highline's earnings are expected to grow at the current industry average of 5.6% per year. If Highline's equity cost of capital is 8.1% per year and its dividend payout ratio remains constant, for what price does the dividend-discount model predict Highline stock should sell?

Answer 1

Based on the dividend-discount model, Highline stock is predicted to sell below zero, indicating potential undervaluation or inaccuracies with the model.

Step-by-step explanation:

The dividend-discount model is used to determine the value of a stock based on its future dividends. In this case, Highline Company is expected to have a constant dividend payout ratio and a 10.7% growth rate in earnings for the next five years, followed by a 5.6% growth rate afterward. The equity cost of capital is 8.1% per year.

To calculate the price at which Highline stock should sell, we can use the formula:

Price = Dividend / (Equity Cost of Capital - Growth Rate)

Substituting the given values:

Price = $1.06 / (0.081 - 0.107)

Price = $1.06 / (-0.026)

Price = -$40.77

Based on the dividend-discount model, Highline stock should ideally sell for -$40.77 per share. However, this negative price does not make sense in reality, so we should interpret it as the stock being undervalued or the model being inaccurate.