Question

Drake Custom Cycles' common stock currently pays no dividends. The company plans to begin paying dividends beginning 3 years from today. The first dividend will be $3.00, and dividends will grow at 5 percent per year thereafter. Given a required return of 15 percent, what would you pay for the stock today

Answer 1

The maximum price that should be paid for this stock today is $20.71

Step-by-step explanation:

The company will pay its first dividend in Year 3 which means the dividend of $3 is D3. Using the constant growth model of DDM we can calculate the price of this stock at year 3. We will discount back that to the present value to calculate the price of the stock today. the price at year 3 using the constant growth model will be,

P3 = D4 / r - g

P3 = 3 * (1+0.05) / (0.15 - 0.05)

P3 = $31.5

The maximum price that should be paid for this stock today is,

P0 = 31.5 / (1+0.15)^3

P0 = $20.71