Better Plastics is a mature manufacturing firm. The company just paid a $4 annual dividend, but management expects to reduce the payout by 3 percent per year, indefinitely. If you require a 12 percent return on this stock, what will you pay for a share today?

Question

Quizplus · Accepted Answer

The dividend discount model can be used to solve this problem:

D1 = $4*(1-0.03) = $3.88 (expected dividend for next year)

P0 = D1/(r-g) = $3.88/(0.12-0.03) = $43.11

However, we are asked for the price of the stock today, so we need to discount the future price back to the present:

P0 = $43.11/(1+0.12) = $38.45

Therefore, the stock is worth $38.45 today. The closest answer choice is B, $25.87, which is the rounded answer to the nearest cent.

Better Plastics Is a Mature Manufacturing Firm