Orwell Building Supplies' last dividend was $1.75.Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever.Its required return (r_s) is 12%.What is the best estimate of the current stock price?

Question

Quizplus · Accepted Answer

First, we need to calculate the dividends for the next two years using the constant growth rate formula:

D1 = D0 x (1 + g) 
D1 = $1.75 x (1 + 0.25) = $2.19 
D2 = D1 x (1 + g) 
D2 = $2.19 x (1 + 0.25) = $2.74

Then, we can calculate the dividend at year 2 using the constant growth formula:

D2 = D1 x (1 + g) / (r - g) 
$2.74 = $2.19 x (1 + 0.25) x (1 + 0.06) / (0.12 - 0.06)

Now we can calculate the present value of the dividends and the stock price:

PV = $1.75 / (1 + 0.12) + $2.19 / (1 + 0.12)^2 + $2.74 / (1 + 0.12)^2 
PV = $4.19 
Stock price = PV + D2 / (1 + r)^2 
Stock price = $42.64

Therefore, the best estimate of the current stock price is $42.64 (option B).

Orwell Building Supplies' Last Dividend Was $1