Question

Beachballs, Inc., expects abnormally high earnings for the next three years due to the forecast of unusually hot summers. After the 3-year period, their growth will level off to its normal rate of 6%. Dividends and earnings are expected to grow at 20% for years 1 and 2 and 15% in year 3. The last dividend paid was $1.00. If an investor requires a 10% return on Beachballs, the price she is willing to pay for the stock is closest to:

Answer 1

Answer: $36.50

Step-by-step explanation:

The price she will be willing to be paid according to the Dividend Discount model is calculated by finding the present value of the future dividends and the terminal value.

Dividend year 1 = 1 * (1 + 20%) = $1.20

Dividend year 2 = 1.20 * (1 + 20%) = $1.44

Dividend year 3 = 1.44 * (1 + 15%) = $1.656

Terminal value = Dividend in year 4 / (required return - growth rate)

= (1.656 * (1 + 6%)) / ( 10% - 6%)

= $43.884

`Price = (1.2)/((1 + 0.10)) + (1.44)/((1 + 0.10)^(2) ) + (1.656)/((1 + 0.10)^(3) ) + (43.884)/((1 + 0.10)^(3) )\\\\= 36.4959\\\\= 36.50`

= $36.50