Question

6. The DAP Company has decided to make a major investment. The investment will require a substantial early cash out-flow, and inflows will be relatively late. As a result, it is expected that the impact on the firm's earnings for the first 2 years will be a negative growth of 5% annually. Further, it is anticipated that the firm will then experience 2 years of zero growth after which it will begin a positive annual sustainable growth of 6%. If the firm's cost of capital is 10% and its current dividend (D0) is $2 per share, what should be the current price per share?

Answer 1

Answer:

The DAP Company

Current price per share:

Current price = Current Dividend (D0) / (WACC - Growth Rate)

= $2/ (0.10 - 0.06) = $50

Explanation:

The technique used to value the share price is called the Dividend Discount Model (DDM).  The Myron Gordon model of this DDM is popularly used.

This model states that the current price of a share is the Current Dividend (D0) divided the difference between the cost of capital and the growth rate.

The result is the intrinsic value of the stock.  The model assumes that dividends are paid in perpetuity and that the growth rate is constant over many years.

These remain assumptions as the real life offers quite different scenarios.  There is no company that pays dividend every year in perpetuity.   A company's growth rate is never constant year on year.