NYC Company has decided to make a major investment.The investment will require a substantial early cash outflow,and inflows will be relatively late.As a result,it is expected that the impact on the firm's earnings for the first 2 years will cause a negative growth of 5 percent annually.Further,it is anticipated that the firm will then experience 2 years of zero growth,after which it will begin a positive annual sustainable growth of 6 percent.If the firm's required return is 10 percent and its last dividend,D₀,was $2 per share,what should be the current price per share?

Question

Quizplus · Accepted Answer

To calculate the current price per share, we can use the Dividend Discount Model (DDM) for a company with varying growth rates. Given the last dividend (D0) of $2, the growth rates, and the required return, we can calculate the price as follows:1. Calculate the dividends for the first 4 years:   - Year 1: D1 = D0 * (1 - 0.05) = $2 * 0.95 = $1.90   - Year 2: D2 = D1 * (1 - 0.05) = $1.90 * 0.95 = $1.805   - Year 3: D3 = D2 * (1 + 0.00) = $1.805 * 1 = $1.805   - Year 4: D4 = D3 * (1 + 0.00) = $1.805 * 1 = $1.8052. Calculate the terminal value at the end of year 4 using the Gordon Growth Model, since from year 5 onwards, the growth becomes constant at 6%:   - D5 = D4 * (1 + 0.06) = $1.805 * 1.06 = $1.9133   - Terminal Value at end of Year 4 = D5 / (r - g) = $1.9133 / (0.10 - 0.06) = $47.83253. Discount the dividends and the terminal value back to present value:   - PV of D1 = $1.90 / (1 + 0.10)^1 = $1.7273   - PV of D2 = $1.805 / (1 + 0.10)^2 = $1.4917   - PV of D3 = $1.805 / (1 + 0.10)^3 = $1.3552   - PV of D4 = $1.805 / (1 + 0.10)^4 = $1.2311   - PV of Terminal Value = $47.8325 / (1 + 0.10)^4 = $31.68874. Sum the present values to get the current price per share:   - Price = $1.7273 + $1.4917 + $1.3552 + $1.2311 + $31.6887 = $38.494Rounding to two decimal places, the closest answer is $38.47, which is option D.

NYC Company Has Decided to Make a Major Investment