Chill Pill Pharmaceuticals is expecting a growth rate of 14% for the next two years due to its new drug. Thereafter it should level to an 8% growth rate. The last dividend paid was $0.65 per share. What price should the stock sell for if investors require 12% return?

Question

Quizplus · Accepted Answer

Step 1:
Calculate the dividend for next two years using the constant growth formula:

D1 = D0 x (1 + g)
D2 = D1 x (1 + g)

Where:
D0 = Last dividend paid = $0.65
g = Growth rate for the next two years = 14%

D1 = $0.65 x (1 + 0.14) = $0.741
D2 = $0.741 x (1 + 0.14) = $0.844

Step 2:
Calculate the expected price of the stock after two years:

P2 = D2 / (r - g)

Where:
r = Required rate of return = 12%
g = Growth rate after two years = 8%

P2 = $0.844 / (0.12 - 0.08) = $21.10

Step 3:
Calculate the present value of the stock using the dividend discount model:

P0 = D1 / (1 + r) + P1 / (1 + r)^2

Where:
P1 = Expected price of the stock after two years = $21.10

P0 = ($0.741 / (1 + 0.12)) + ($21.10 / (1 + 0.12)^2) = $19.47

Therefore the best choice is C, $19.47.

Chill Pill Pharmaceuticals Is Expecting a Growth Rate of 14