Question

13. Firm G is a mature manufacturing firm. The company just paid a $12 dividend, but management expects to reduce the payout by 10 percent per year indefinitely. If you require an 15 percent return on this stock, what will you pay for a share today

Answer 1

The maximum that should be paid for a share of stock today is $43.2

Step-by-step explanation:

Using the constant growth model of dividend discount model, we can calculate the price of the stock today. 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 = D0 * (1+g) / (r - g)

Where,

• Do is the last dividend paid

• D0 * (1+g) is dividend expected for the next period or D1

• g is the growth rate

• r is the required rate of return

As the payout is being reduced, we can say that g or growth rate is negative 10%.

Using the above formula to calculate the price of the stock today,

P0 = 12 * (1 - 0.1) / (0.15 - (-0.1))

P0 = $43.2