Question

A stock just paid an annual dividend of $1.10. The dividend is expected to increase by 10 percent per year for the next two years and then increase by 2 percent per year thereafter. The discount rate is 14 percent. What correctly computes the current stock price?

Answer 1

Answer: $10.79

Step-by-step explanation:

This requires the use of the Dividend Discount Model.

The price of the stock is the present value of the dividends for the two years and then the Terminal value.

Terminal value = Third year dividend / (Required return - Growth rate)

= (1.10 * 1.10² * 1.02) / (14% - 2%)

= 1.35762 / 12%

= $11.31

Price of stock is:

= Present value of first year dividend + Present value of second year dividend + Present value of Terminal value

= ((1.10 * 1.1) / 1.14) + (( 1.10 * 1.1²) / 1.14²) + (11.31 / 1.14²)

= $10.79