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A company is expected to pay their first annual dividend 2 years from now. That payment will be...

Question:

A company is expected to pay their first annual dividend 2 years from now. That payment will be $1.50 a share. Starting in Year 3, the company will increase the dividend by 5% per year. The required return from common shareholders is 15%. What is the estimated value of this stock today?

Dividend Growth Model

Dividend growth model is important as it is used in valuation of companies that pay dividends constantly. The value of the stock is the sum of all the present value of all the future dividends.

Answer and Explanation:

The price is computed as follows using the dividend model;

  • The value of fist annual dividend = $1.50

The terminal value given;-

  • Required return =15%
  • Dividend growth = 5%

{eq}P0 = D1 / (Ke - g) {/eq}

where:

  • P0 = Price of a stock
  • D1 = Next year's dividend
  • Ke = Cost of equity capital
  • g = Growth rate in dividends

{eq}P0 = 1.50(1+0.05)/(0.15-0.05) = 15.75 {/eq}

The value of the stock is;

{eq}value = (D1+p0)/(1+r)^{2} {/eq}

{eq}value = (1.50 + 15.75)/(1+0.15)^{2} = $13.04 {/eq}

The estimated value of this stock today is $13.04


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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