Nu Electronics is expecting a period of intense growth. Thus, the company has decided to retain more of its earnings to help finance the growth. As a result, the company is going to reduce the annual dividend by 25% a year for the next 2 years. After that, it will maintain a constant dividend of $.50 a share. Last year, the company paid $2 per share. What is the market value of this stock if the required rate of return is 14%?
A) $3.79
B) $4.01
C) $4.32
D) $4.93
E) $5.62

Question

Quizplus · Accepted Answer

The market value of the stock can be calculated using the dividend discount model for a period of changing dividends followed by constant dividends. The dividends for the next two years are reduced by 25% each year from the last year's dividend of $2. So, the dividends are:Year 1: $2 * (1 - 0.25) = $1.50Year 2: $1.50 * (1 - 0.25) = $1.125After year 2, the dividend is constant at $0.50 per share. The present value of these dividends plus the present value of the perpetuity starting from year 3 can be calculated as follows:PV of Year 1 Dividend = $1.50 / (1 + 0.14)^1 = $1.3158PV of Year 2 Dividend = $1.125 / (1 + 0.14)^2 = $0.8681The constant dividend starts in year 3, so we use the perpetuity formula starting from that point. The present value of a perpetuity is calculated as Dividend / Rate of Return. However, we need to discount it back to present value from year 2:PV of Perpetuity from Year 3 = $0.50 / 0.14 = $3.5714Discounted to present value from the end of year 2: $3.5714 / (1 + 0.14)^2 = $2.7591Adding these up gives the total present value (market value) of the stock:$1.3158 + $0.8681 + $2.7591 = $4.93

Nu Electronics Is Expecting a Period of Intense Growth