USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Davenport Corporation's last dividend was $2.70, and the directors expect to maintain the historic 3 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 5 percent for the next three years and the stock will then reach $25 per share.
-Refer to Exhibit 8.1. How much should you be willing to pay for the stock if you require a 17 percent return?
A) $16.97
B) $22.16
C) $21.32
D) $32.63
E) $23.63

Question

Quizplus · Accepted Answer

Using the constant growth model, we can calculate the price of the stock as follows:

D1 = D0 * (1 + g)
D1 = $2.70 * (1 + 0.05)
D1 = $2.835

D2 = D1 * (1 + g)
D2 = $2.835 * (1 + 0.05)
D2 = $2.977

D3 = D2 * (1 + g)
D3 = $2.977 * (1 + 0.05)
D3 = $3.126

P3 = D3 / (r - g)
P3 = $3.126 / (0.17 - 0.05)
P3 = $26.05

P0 = P3 / (1 + r)^3
P0 = $26.05 / (1 + 0.17)^3
P0 = $22.16

Therefore, you should be willing to pay $22.16 for the stock if you require a 17 percent return. The answer is choice B.