Question

Declining Products Corporation produces goods that are very mature in their product life cycles. Declining Products is expected to pay a dividend in year 1 of $1.33, a dividend of $1.23 in year 2, and a dividend of $1.18 in year 3. After year 3, dividends are expected to decline at a rate of 2% per year. An appropriate required rate of return for the stock is 8%. What should the stock be worth

Answer 1

P0 = $18.5225 rounded off to $18.52

Step-by-step explanation:

Using the dividend discount model, we can calculate the price of the stock today. The DDM values the stock based on the present value of the expected future dividends from the stock. The formula to calculate the price of the stock is,

P0 = D1 / (1+r) + D2 / (1+r)^2 + ... + Dn / (1+r)^n + [Dn * (1+g) / (r - g)] / (1+r)^n

Where,

• D1 is the dividend expected in year 1
• r is the required rate of return
• g is the constant growth rate in dividends

As the dividends will decline after 3 at a constant rate, the g will be -2%.

P0 = 1.33 / (1+0.08) + 1.23 / (1+0.08)^2 + 1.18 / (1+0.08)^3 +

[1.18 * (1-0.02) / (0.08 - 0.02)] / (1+0.08)^3

P0 = $18.5225 rounded off to $18.52