Question

Dividend discount model.

Consider 3 stocks:
a. Stock A is expected to provide a dividend of $10/share forever.
b. Stock B is expected to pay a $5 dividend next year. Thereafter, dividend growth is expected to be 4% a year forever.
c. Stock C is expected to pay a $5 dividend next year. Thereafter, growth is expected to be 20% a year for 5 years (years 2 through 6) and 0 thereafter.
If the market capitalization rate for each stock is 10%, which stock is the most valuable?

Answer 1

stock A is the most valuable since it is worth $100

Step-by-step explanation:

Price of stock A = $10 / 10% = $100

Price of stock B = $5 / (10% - 4%) = $83.33

Price of stock C:

P₁ = $5 / 1.1 = $4.5454

P₂ = $6 / 1.1² = $4.9587

P₃ = $7.20 / 1.1³ = $5.4095

P₄ = $8.64 / 1.1⁴ = $5.9012

P₅ = $10.368 / 1.1⁵ = $6.4377

P₆ = terminal value = $12.4416 / 0.1 = $124.416, now we discount it at 10% per year = $124.416 / 1.1⁶ = $70.2296

P₀ = P₁ + P₂ + P₃ + P₄ + P₅ + P₆ = $97.48