Question

CHERCRO Inc. is a startup. It is estimated that the company will not be paying any dividends for the coming 4 years. If the company distributes $3 per share 5 years from today, the growth rate of the dividends will be 2% per year going forward. If, instead the company distributes $2 per share at the 5th year, the growth rate of dividends will be 6% per year. As an investor of CHERCRO, which policy would you support if the market rate is 12%? (Hint: the value of a share is the expected present value of the entire future dividend stream)

Answer 1

Policy 1

Price at end of year 4 = D5/(rs-g)

= 3 /(.12-.02)

= 3/.10

= $ 30 per share

Price Today =PVF12%,4* Price at end of year 4

= .63552 * 30

= $ 19.07 PER SHARE

Policy 2 :

Price at end of year 4 = D5/(rs-g)

= 2 /(.12-.06)

= 3/.06

= $ 50 per share

Price Today =PVF12%,4* Price at end of year 4

= .63552 * 50

= $ 31.78 PER SHARE

Policy 2 should be adopted since market price per share is higher under policy 2.