Question

Assume IBM is expected to pay a total cash dividend of $4.35 next year and dividends are expected to grow indefinitely by 2.6 percent a year. Assume the required rate of return (i.e. equity holder's opportunity cost of capital) is 9.3 percent. Assuming this is the best information available regarding the future of this firm, what would be the most economically rational value of the stock today (i.e. today's "price")

Answer 1

$65

Step-by-step explanation:

Gordon Growth model seeks to calculate stock price today by discounting the future dividends. There are two forms of the model

1) Stable Growth indefinitely: Assumes certain % of growth in dividend payment indefinitely.

2) Multi stage growth: Assumes different % growth in dividend for different time periods (e.g. 5% for next two years and than 2% indefinitely etc.)

In our case the it is stable growth rate of 2.6% indefinitely, so the price is calculated using following formula:

Price = Next year Dividend / (Rate of return - Growth rate)

Price = 4.35 / (9.3% - 2.6%)

Price = $65