Genestek Inc. just paid a $5.00 dividend. Due to a new product about to be released, analysts expect the company to grow at a supernormal rate of 15% for three years. After that it is expected to grow at a normal rate of 4% indefinitely. Stocks similar to Genestek are currently earning shareholders a return of 12%. The estimated selling price of the stock is:

Question

Quizplus · Accepted Answer

The estimated selling price of the stock can be calculated using the dividend discount model (DDM) for a stock with supernormal growth for a finite period followed by perpetual growth. First, calculate the dividends for the first three years using the supernormal growth rate of 15%, then calculate the price at the end of year 3 using the perpetual growth rate of 4%, and finally discount all future cash flows back to the present value using the required rate of return of 12%.1. Calculate future dividends:- Year 1: $5.00 * (1 + 0.15) = $5.75- Year 2: $5.75 * (1 + 0.15) = $6.61- Year 3: $6.61 * (1 + 0.15) = $7.602. Calculate the selling price at the end of year 3 using the Gordon Growth Model (also known as the Perpetual Growth Model):$$ P_3 = \frac{D_4}{r - g} = \frac{7.60 * (1 + 0.04)}{0.12 - 0.04} = \frac{7.90}{0.08} = \$98.75 $$3. Discount all future cash flows (dividends and selling price) back to the present value:$$ PV = \frac{5.75}{(1 + 0.12)} + \frac{6.61}{(1 + 0.12)^2} + \frac{7.60 + 98.75}{(1 + 0.12)^3} $$$$ PV = \frac{5.75}{1.12} + \frac{6.61}{1.2544} + \frac{106.35}{1.404928} $$$$ PV = 5.13 + 5.27 + 75.70 = 86.10 $$Therefore, the estimated selling price of the stock is $86.10.