Question

The Ramirez Company's last dividend was $1.5. Its dividend growth rate is expected to be constant at 15% for 2 years, after which dividends are expected to grow at a rate of 5% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price?

Answer 1

Answer:

current stock price, $P_{0}$ = $26.84

Explanation:

Given,

Most recent dividend, $D_{0}$ = $1.50

Growth rate, $g_{1}$ = 15% = 0.15 (Next 2 years)

$g_{2}$ = 5% = 0.05 (remain constant after 2 years)

required rate of return , $r_{s}$ = 12% = 0.12

We know,

Current stock price, $P_{0}$ = [$D_{1}$ ÷ (1 + $r_{s}$)] + $\frac{D_{2} + P_{2}}{(1 + r_{s})^{2}}$

or, $P_{0}$ = [{$D_{0}$ × (1 + $g_{1}$)} ÷ (1 + $r_{s}$)] + $\frac{D_{0} (1 + g_{1})^{2} + \frac{D_{3}}{r_{s} - g_{2}}}{(1 + r_{s})^{2}}$

or, $P_{0}$ = [{$1.50 × (1 + 0.15)} ÷ (1 + 0.12)] + $\frac{1.50*(1+0.15)^{2} + \frac{D_{2} (1 + g_{2})}{(0.12 - 0.05)}}{(1+0.12)^{2}}$

or, $P_{0}$ = ($1.725 ÷ 1.12) + $\frac{1.98375 + \frac{1.98375*(1 + 0.05)}{0.07}}{1.2544}$

or, $P_{0}$ = $1.5402 + [(1.98375 + 29.75625) ÷ 1.2544]

or, $P_{0}$ = $1.5402 + (31.74 ÷ 1.2544)

or, $P_{0}$ = $1.5402 + 25.3029

Therefore, current stock price, $P_{0}$ = $26.84