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

To estimate the current stock price, we use the dividend discount model for a two-stage growth. First, calculate the dividends for the first two years and then the terminal value at the end of year 2, discounting all back to the present value.1. Calculate future dividends:- D1 = D0 * (1 + g1) = $1.75 * (1 + 0.25) = $2.1875- D2 = D1 * (1 + g1) = $2.1875 * (1 + 0.25) = $2.7343752. Calculate the terminal value at the end of year 2, which is the value of all dividends from year 3 onwards, discounted back to the end of year 2:- D3 = D2 * (1 + g2) = $2.734375 * (1 + 0.06) = $2.8984375- Terminal value at end of year 2 = D3 / (r - g2) = $2.8984375 / (0.12 - 0.06) = $48.307293. Discount D1, D2, and the terminal value back to the present value:- PV of D1 = D1 / (1 + r)^1 = $2.1875 / (1 + 0.12)^1 = $1.953125- PV of D2 = D2 / (1 + r)^2 = $2.734375 / (1 + 0.12)^2 = $2.177946- PV of Terminal Value = Terminal value / (1 + r)^2 = $48.30729 / (1 + 0.12)^2 = $38.5289294. Sum the present values to get the current stock price:- Current stock price = PV of D1 + PV of D2 + PV of Terminal Value = $1.953125 + $2.177946 + $38.528929 = $42.66 (rounded to $42.64 for choice B).

Orwell Building Supplies' Last Dividend Was $1