Question

Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next 8 years because the firm needs to plow back its earnings to fuel growth. The company will then pay a dividend of $16.50 per share 9 years from today and will increase the dividend by 5.75% per year thereafter. The required return on the stock is 13.75%. What is the price of the stock 8 years from today? What is the current share price?

Answer 1

The price of the stock 8 years from today will be $206.25

The current price of the stock is $73.58

Step-by-step explanation:

The constant growth model of DDM is used to calculate the price of a stock whose dividends are expected to grow at a constant rate. The DDM values a stock based on the present value of the expected future dividends from the stock. The formula for price today under this model is,

P0 = D1 / (r - g)

Where,

• D1 is the dividend expected for the next period or D0 * (1+g)
• r is the required rate of return
• g is the constant growth rate

To calculate the price today, we use the dividend expected for the next year/period. Thus, to calculate the price at Year 8 or P8, we will use the dividend in Year 9 or D9.

P8 = D9 / (r - g)

P8 = 16.5 / (0.1375 - 0.0575)

P8 = $206.25

To calculate the current price of the stock, we will discount back the price at Year 8 to today. We will use the present value formula. The present value of an amount is,

PV = FV / (1+r)^n

Where,

• FV is the future value
• n is the number of years or period
• r is the required rate of return

PV or P0 = 206.25 / (1+0.1375)^8

PV or price today = $73.58