Final answer:
The valuation of Highline Company's stock using the dividend-discount model is determined by calculating the present value of predicted dividends during an initial high growth period and a subsequent perpetual growth period, using the specified growth rates and cost of equity capital.
Step-by-step explanation:
The student is asking about the valuation of Highline Company using the dividend-discount model (DDM). The DDM is a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. Given that Highline has just paid a dividend of $1.03 and is expected to grow at 10.9% for the next five years before leveling to a growth rate of 4.9%, and considering an equity cost of capital at 7.7%, we need to calculate the price of the stock. The calculation involves finding the present value of the forecasted dividends during the high growth period and adding it to the present value of all subsequent dividends, assuming a constant growth rate into perpetuity.
Firstly, we calculate the dividends for the next five years which will be growing at a rate of 10.9%. These dividends are then discounted back to the present value using the cost of equity capital, 7.7%. After the fifth year, we will use the Gordon Growth Model to calculate the terminal value of the stock, which assumes a perpetuity growth rate of 4.9%. The formula used is the last high growth dividend multiplied by (1 + long-term growth rate) divided by (cost of equity - long-term growth rate). This value is then discounted back to its present value. Finally, the sum of the present values of the dividends and the terminal value gives us the fair price of the stock.