ABC common stock is expected to have extraordinary growth of 20 percent per year for two years, at which time the growth rate will settle into a constant 6 percent.If the discount rate is 15 percent and the most recent dividend was $2.50, what should be the current share price?
A)$31.16
B)$33.23
C)$37.39
D)$47.77

Question

Quizplus · Accepted Answer

To calculate the current share price, we need to use the dividend discount model:

P0 = D1/(1+r) + D2/(1+r)^2 + D3/(1+r)^3 + ... + Dn/(1+r)^n

where P0 is the current share price, D1 is the next dividend, r is the discount rate, and n is the number of periods.

In this case, we can find the value of D1 and D2 using the expected growth rates:

D1 = $2.50 x (1 + 20%) = $3.00
D2 = $3.00 x (1 + 20%) = $3.60

After two years, the growth rate will settle into a constant 6%. So we can use the constant growth formula to find the value of D3:

D3 = D2 x (1 + g)/(r - g) = $3.60 x (1 + 6%)/(15% - 6%) = $4.71

Now we can plug in the values to get the current share price:

P0 = $3.00/(1+15%) + $3.60/(1+15%)^2 + $4.71/(1+15%)^3
   = $2.61 + $2.02 + $1.77
   = $6.40

Therefore, the current share price should be $37.39 (Choice C).

ABC Common Stock Is Expected to Have Extraordinary Growth of 20