Question

Davenport Corporation's last dividend was $2.70, and the directors expect to maintain the historic 3% annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 5% for the next three years and the stock will then reach $25 per share.1. How much should you be willing to pay for the stock if you require a 17% return? 2. How much should you be willing to pay for the stock if yo feel that the 5% growth rate can be maintained indefinitely and you require a 17% return?

Answer 1

A) $22.16 per share

B) $23.625

Explanation:

Price to be paid for the stock today is equal to the present value of expected inflows we can find price by multiplying the dividend with the growth rate then dividing it by the required rate of return.

Price = Dividend(1+growth rate) / 1+ required return

Data

Dividend = 2.7

Required return = 17%

Growth rate = 5%

1) year1 year2 year3 year3

Price =
`(2.7(1.05))/((1.17)) +(2.7(1.05)^2)/((1.17)^2)+(2.7(1.05)^3)/((1.17)^3)+(25)/((1.17)^3)`

Price = $22.16 per share

2)

Price to be paid =
`(2.7(1.05))/(0.17-0.05)`

Price to be paid = $23.625