Babbalu Inc. just paid a dividend of S1 per share. Babbalu expects to increase its annual...

Question:

Babbalu Inc. just paid a dividend of S1 per share. Babbalu expects to increase its annual dividend by 20% per year for the next two years and by 15% per year for the following two years. Starting in year 5, Babbalu is expected to pay a constant annual dividend of S3 a share. What is the current value of this stock if the required rate of return is 12%?

a. $17.71

b. $18.97

c. $20.50

d. $21.08

Dividend Growth Model:

According the dividend growth model, the price of a stock depends on the expected dividend per share, the expected growth rate of dividend as well as the required rate of return. The higher the growth rat or the lower the required return, the higher the stock price.

Answer and Explanation:

The answer is c).

We can use the dividend discount model to compute the price. According to this model, the price of a stock is the discounted present value of future dividends, i.e.,

  • {eq}\dfrac{1*(1+20\%)}{(1 + 12\%)} + \dfrac{1*(1 + 20\%)^2}{(1 + 12\%)^2} + \dfrac{1*(1 + 20\%)^2*(1 + 15\%)}{(1 + 12\%)^3} + \dfrac{1*(1 + 20\%)^2*(1 + 15\%)^2}{(1 + 12\%)^4} + \dfrac{3}{12\%(1 + 12\%)^4}\\ = 4.61 + 15.89\\ = 20.50 {/eq}

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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