Question

Railway Cabooses just paid its annual dividend of $1.50 per share. The company has been reducing the dividends by 11.2 percent each year. How much are you willing to pay today to purchase stock in this company if your required rate of return is 12 percent?

Answer 1

Using the dividend discount model for declining dividends, one would calculate the present value of the expected future dividend stream from Railway Cabooses, given the annual reduction in dividends and the required rate of return, to determine the current fair stock price.

Step-by-step explanation:

The question involves calculating the present value of a declining dividend stream that Railway Cabooses is expected to pay in the future. Given the annual dividend of $1.50 per share and a reduction rate of 11.2 percent each year, along with a required rate of return of 12 percent, we can use the dividend discount model for a stock with declining dividends to determine the present value and thus, how much one would be willing to pay for the stock today.

To find the present value of each future dividend, we can use the following formula: Present Value (PV) = D / (1 + r)^n, where D is the dividend, r is the required rate of return, and n is the number of years in the future. However, due to the dividend decline rate, we must adjust the dividend each year by the decline rate. The series of adjusted dividends is then discounted back to its present value at the rate of 12 percent.