Question

This year, Midland Light and Gas (ML\&G) paid its stockholders an annual dividend of $1.50 a share. A major brokerage firm recently put out a report on ML\&G predicting that the company's annual dividends should grow at the rate of 5% pe year for each of the next seven years and then level off and grow at the rate of 2% a year thereafter. (Note: Use four decimal places for all numbers in your intermediate calculations.) a. Use the variable-growth DVM and a required rate of return of 11.00% to find the maximum price you should be willing to pay for this stock. b. Redo the ML\&G problem in part a, this time assuming that after year 7 , dividends stop growing altogether (for year 8 and beyond, g=0 ). Use all the other information given to find the stock's intrinsic value. c. Contrast your two answers and comment on your findings. How important is growth to this valuation model?

Answer 1

To find the maximum price to pay for the ML&G stock, use the Dividend Valuation Model. The maximum price is $26.25 for the first seven years and $19.59375 for years 8 and beyond.

Step-by-step explanation:

To find the maximum price you should be willing to pay for the ML&G stock, you can use the Dividend Valuation Model (DVM). The DVM formula is D1/(r-g), where D1 is the next year's expected dividend, r is the required rate of return, and g is the growth rate. In this case, the annual dividend is $1.50 and the required rate of return is 11%. The growth rate is 5% for the first seven years and then levels off to 2%.

Using the DVM formula:

For the first seven years, g = 5%:

D1 = $1.50 * (1 + 0.05) = $1.575

Max price = $1.575 / (0.11 - 0.05) = $26.25

For years 8 and beyond, g = 2%:

D1 = $1.575 * (1 + 0.02) = $1.6065

Max price = $1.6065 / (0.11 - 0.02) = $19.59375