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Huang Company's last dividend was $1.25. The dividend growth rate is expected to be constant at...

Question:

Huang Company's last dividend was $1.25. The dividend growth rate is expected to be constant at 27.5% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price?

Dividend Growth Model

Dividend growth model is a model that is used to predict the value of a stock only for the companies that pay dividends regularly. If a stock pays dividends,the sum of the present value of all the future dividends paid is the value of the stock.

Answer and Explanation:

The price is computed as follows using the dividend model;

The CGDM formula is;

{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

Given;-

D0 = $1.25

  • Growth = 27.5% for 3 years

Therefore;

{eq}D1 = 1.25(1+0.275) = 1.59 {/eq}

{eq}D2 = 1.59(1+0.275) = 2.03 {/eq}

{eq}D3 = 2.03(1+0.275) = 2.59 {/eq}

To calculate the terminal value Po

{eq}P0 = D3 / (Ke - g) {/eq}

{eq}P0 = 2.59(1+0.06) / (0.11 - 0.06) = 54.908 {/eq}

The value of the stock is;

{eq}value = D1/(1+r)^{1} +D2/(1+r)^{2}+ (D3+p0)/(1+r)^{3} {/eq}

{eq}value = 1.59/(1+0.11)^{1} + 2.03/(1+0.11)^{2} + 2.59 + 54.908/(1+0.11)^{3} = 45.12 {/eq}

The value of the stock is $45.12


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
9.8K

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