Question

stock is not expected to pay dividends until three years from now. The dividend is then expected to be $2.00 per share, the dividend payout ratio is expected to be 40%, and the return on equity is expectedto be 15%. If the required rate of return is 12%, the value of the stock today is closest to:

Answer 1

Answer:

The value of the stock today is closest to $53.15

Explanation:

Under the Gordon Growth Model, the share price of share can be calculated as follow  

Price of share = D / ( k - g )

Where:

D = End of the first period Dividend  

k = Required Rate of Return

g = Expected growth rate

g can be calculated as follow

g = Retention Rate x and ROE

g = ( 1- Dividend Payout Ratio )  x ROE

g = ( 100% - 40% )x 15%  = 60% x 15%  = 9%

D = $2

k = 12%

Dividends will start at year 3. This will be after 2 years of the end of the year dividend.

Year 3 share Price = $2 / ( 12% - 0.09% )

Year 3 share Price = $66.67  

Discounting the year 3 share price back to today's value,

Today's share price = Year 3 share Price / ( 1 + required ROR )^n

Today's share price = 66.67 / ( 1 + 12% )^2

Today's share price = $53.15