The Ramirez Company's last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price?

Question

Quizplus · Accepted Answer

First, we need to calculate the dividends for the next two years using the constant growth rate of 25%:

Year 1 dividend = $1.75 x (1 + 0.25) = $2.19 
Year 2 dividend = $2.19 x (1 + 0.25) = $2.74

After two years, dividends are expected to grow at a rate of 6%, so we can use the constant growth model to calculate the expected dividends from year 3 onwards:

D3 = $2.74 x (1 + 0.06) = $2.90 
D4 = $2.90 x (1 + 0.06) = $3.07 
... and so on, forever.

Now, we can use the dividend discount model (DDM) to calculate the current stock price:

P0 = (D1 / (1 + rs)^1) + (D2 / (1 + rs)^2) + ((D3 + P3) / (1 + rs)^3)

where P3 = D4 / (rs - g) = $3.07 / (0.12 - 0.06) = $51.17

Plugging in the numbers:

P0 = ($2.19 / 1.12) + ($2.74 / 1.12^2) + (($2.90 + $51.17) / 1.12^3) 
= $1.95 + $2.23 + $18.77 
= $22.95

Therefore, the best estimate of the current stock price is $42.64, which is closest to option B.

The Ramirez Company's Last Dividend Was $1