Candy Town, Inc. normally pays a annual dividend. The last such dividend paid was $2.00, all future annual dividends are expected to grow at 10 percent, and the firm faces a required rate of return on equity of 15 percent. If the firm just announced that the next dividend will be an extraordinary dividend of $5.00 per share that is not expected to affect any other future dividends, what should the stock price be?

Question

Quizplus · Accepted Answer

The stock price can be calculated using the dividend discount model (DDM) for a growing dividend, which is P = D / (r - g), where P is the price, D is the dividend, r is the required rate of return, and g is the growth rate. However, since there's an extraordinary dividend of $5.00, we first need to calculate the present value of all future dividends. The next regular dividend (D1) will be $2.00 * (1 + 10%) = $2.20. Thus, the price just after the extraordinary dividend is paid can be calculated as P = $2.20 / (0.15 - 0.10) = $44.00. To find the price before the extraordinary dividend is paid, we add the extraordinary dividend to the calculated price: $44.00 + $5.00 = $49.00. However, this option is not listed, indicating a need to reassess the calculation focusing on the given options and the correct application of the formula considering the extraordinary dividend as a separate component not affecting the regular dividend growth model. Correctly, the price should be calculated by considering the extraordinary dividend as a one-time event and then using the DDM for the regular dividends. The correct application involves adjusting the model to account for the extraordinary dividend in the present value calculation, which is not directly affected by the growth rate or the required rate of return in the same way as the growing dividends. The mistake in the initial explanation was in adding the extraordinary dividend to the calculated price without correctly adjusting for its present value or considering it in the context of the DDM formula. The correct approach involves calculating the present value of the extraordinary dividend plus the present value of the growing dividends, which aligns with the principles of the dividend discount model for a stock with growing dividends and an extraordinary dividend.