Suppose a firm's expected dividends for the next three years are as follows: D₁ = $1.10, D₂ = $1.20, and D₃ = $1.30. After three years, the firm's dividends are expected to grow at 5.00 percent per year. What should the current price of the firm's stock (P₀) be today if investors require a rate of return of 12.00 percent on the stock? (Do not round intermediate calculations. Round off final answer to the nearest $0.01)

Question

Quizplus · Accepted Answer

The first step is to calculate the expected dividends in year 3 (D3): D3 = D2*(1+g) = $1.30*(1+0.05) = $1.365 Next, we can use the dividend discount model to calculate the stock price today: P₀ = (D1/(1+r)^1) + (D2/(1+r)^2) + (D3+P3)/(1+r)^3 P₀ = ($1.10/(1+0.12)^1) + ($1.20/(1+0.12)^2) + ($1.365/(1+0.12)^3) P₀ = $0.982 + $0.974 + $1.051 P₀ = $3.007 Finally, we add the present value of the expected future stock price at the end of year 3 (P3): P3 = D4/(r - g) = $1.365/(0.12 - 0.05) = $17.06 P₀ = $3.007 + ($17.06/(1+0.12)^3) P₀ = $3.007 + $13.734 P₀ = $16.74, rounded to the nearest cent. Therefore, the best choice is C.

Suppose a Firm's Expected Dividends for the Next Three Years