Modem Development,Inc.paid a dividend of $5.00 per share on its common stock yesterday.Dividends are expected to grow at a constant rate of 4% for the next two years,at which point the stock is expected to sell for $56.00.If investors require a rate of return on Modem's common stock of 18%,what should the stock sell for today?

Question

Quizplus · Accepted Answer

We can use the dividend discount model to calculate the current stock price:

D1 = D0 x (1 + g) = $5.00 x (1 + 4%) = $5.20

D2 = D1 x (1 + g) = $5.20 x (1 + 4%) = $5.41

P2 = $56.00 (given)

Using the constant growth formula, we can solve for the current stock price:

P0 = D1 / (r - g) + D2 / (1 + r)^2 / (r - g)

Where:

r = 18% (required rate of return)
g = 4% (dividend growth rate)

P0 = $5.20 / (18% - 4%) + $5.41 / (1 + 18%)^2 / (18% - 4%) = $48.51

Therefore, the stock should sell for $48.51 today. The correct answer is B.