Question

"Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next nine years because the firm needs to plow back its earnings to fuel growth. The company will pay a dividend of $10 per share 10 years from today and will increase the dividend by 5 percent per year thereafter. If the required return on this stock is 11.5 percent, what is the current share price

Answer 1

The price per share today will be $57.758

Step-by-step explanation:

The price per share will be calculated using the constant growth model of the DDM as the dividends will grow at a constant rate forever. However, as DDM is only applicable for a dividend paying company and as the dividend is paid from Year 10 and on wards, we will adjust the DDM formula to calculate the price at Year 9 and discount it back using required rate of return to calculate the price today. The formula for price under constant growth model is,

P0 = D1 / r - g

Where D1 is the dividend in year 1 or next period to calculate price today. As we use the next period's dividend, to calculate the price at year 9, we will use D10 that is $10 per share.

The price at year 9 will be given by this equation,

P9 = 10 / (0.115 - 0.05)

And as we require price today, we will discount it back 9 years. So the price today will be,

P0 = (10 / (0.115 - 0.05) / (1+0.115)^9

P0 = $57.758