The Satellite Building Company has fallen on hard times.Its management expects to pay no dividends for the next 2 years.However, the dividend for Year 3, , will be $1.00 per share, and the dividend is expected to grow at a rate of 3 percent in Year 4, 6 percent in Year 5, and 10 percent in Year 6 and thereafter.If the required return for Satellite is 20 percent, what is the current equilibrium price of the stock?
A) $0
B) $5.26
C) $6.34
D) $12.00
E) $13.09

Question

The Satellite Building Company has fallen on hard times.Its management expects to pay no dividends for the next 2 years.However, the dividend for Year 3,  , will be $1.00 per share, and the dividend is expected to grow at a rate of 3 percent in Year 4, 6 percent in Year 5, and 10 percent in Year 6 and thereafter.If the required return for Satellite is 20 percent, what is the current equilibrium price of the stock?
A) $0 
B) $5.26 
C) $6.34 
D) $12.00 
E) $13.09

Quizplus · Accepted Answer

Using the Dividend Discount Model:

PV = D1 / (1+r) + D2 / (1+r)^2 + D3 / (1+r)^3 + ... + P3 / (1+r)^3

PV = 1 / (1+0.2)^1 + 1 / (1+0.2)^2 + 1.03 / (1+0.2)^3 + 1.03*(1+0.06) / (0.2-0.06) / (1+0.2)^3 + 1.03*(1+0.06)^2 / (0.2-0.1) / (1+0.2)^3

PV = 0.833 + 0.694 + 0.827 + 15.854 + 30.985

PV = $48.192

Therefore, the current equilibrium price of the stock is $6.34 (rounded to two decimal places) which is closest to choice (C).

The Satellite Building Company Has Fallen on Hard Times