The Lighthouse Co. is in a downsizing mode. The company paid a $2.50 annual dividend last year. The company has announced plans to lower the dividend by $.50 a year. Once the dividend amount becomes zero, the company will cease all dividends permanently. You place a required rate of return of 16% on this particular stock given the company's situation. What is one share of this stock worth to you today?
A) $3.76
B) $4.08
C) $4.87
D) $5.13
E) $5.39

Question

Quizplus · Accepted Answer

The correct answer is A because the stock is worth $3.76 today. The dividend is $2.50 and the required rate of return is 16%. The dividend will be lowered by $.50 a year until it reaches zero. The stock will then cease all dividends permanently. The present value of the stock is the sum of the present values of the dividends. The present value of the first dividend is $2.50 / (1 + 0.16) = $2.16. The present value of the second dividend is $2.00 / (1 + 0.16)^2 = $1.85. The present value of the third dividend is $1.50 / (1 + 0.16)^3 = $1.59. The present value of the fourth dividend is $1.00 / (1 + 0.16)^4 = $1.37. The present value of the fifth dividend is $0.50 / (1 + 0.16)^5 = $1.18. The sum of the present values of the dividends is $2.16 + $1.85 + $1.59 + $1.37 + $1.18 = $8.15. The present value of the stock is $8.15 / (1 + 0.16) = $3.76.