Question

8. The current price of a stock is $65.88. If dividends are expected to be $1 per share for the next five years, and the required return is 10%, then what should the price of the stock be in 5 years when you plan to sell it? If the dividend and required return remain the same, and the stock price is expected to increase by $1 five years from now, does the current stock price also increase by $1? Why or why not?

Answer 1

Answer:

a). Future price of stock in five years=$98.97

b). The current stock price will not be affected by an increase of $1 in stock price, this is because increase in stock price is a function of the expected dividend growth rate and not the current stock price

Explanation:

a). Use the expression for calculating the required rate of return as to determine the expected dividend growth rate follows:

RRR=(EDP/SP)+DGR

where;

RRR=required rate of return

EDP=expected dividend payment

SP=share price

DGR=dividend growth rate

In our case:

RRR=10%=10/100=0.1

EDP=$1

SP=$65.88

DGR=y

replacing in the original expression;

0.1=(1/65.88)+y

y=0.1-(1/65.88)

y=0.0848

The expected dividend growth rate=8.48%

Future price of stock=Current price(1+DGR)^n

where;

Current price=$65.88

DGR=8.48%=8.48/100=0.0848

n=5 years

replacing;

Future price of stock=65.88(1+0.0848)^5

Future price of stock=$98.97

b). The current stock price will not be affected by an increase of $1 in stock price, this is because increase in stock price is a function of the expected dividend growth rate and not the current stock price