CPU Company currently (t = 0) pays a dividend of $2.50 per share on its common stock.Dividends are expected to increase at the rate of $.25 per share for the next several years.Determine the current value of CPU's common stock to an investor who expects to be able to sell the stock for $35 per share after 3 years, given that the investor requires a 14 percent rate of return on this security.

Question

Quizplus · Accepted Answer

We can use the dividend discount model to calculate the current value of the stock:

D1 = D0 * (1 + g)
Where:
D1 = Dividend next year
D0 = Current dividend
g = Growth rate of dividends

D1 = $2.50 * (1 + 0.25) = $3.125

Then, we can use the present value formula to discount the future dividends and the sale price back to the present:

PV = D1/(1 + r) + D2/(1 + r)^2 + D3/(1 + r)^3 + Sale Price/(1 + r)^3
Where:
r = Required rate of return

PV = $3.125/(1 + 0.14) + $3.375/(1 + 0.14)^2 + $3.625/(1 + 0.14)^3 + $35/(1 + 0.14)^3
PV = $2.732 + $2.292 + $1.935 + $19.58
PV = $26.54

Therefore, the current value of the stock is $26.54, which is closest to choice B ($30.54).

CPU Company Currently (T = 0) Pays a Dividend of $2.50