Description
Question:
Dividend Discount Model. Integrated Potato Chips just paid a $1 per share dividend.
You expect the dividend to grow steadily at a rate of 4% per year. (LO7-2)
a. What is the expected dividend in each of the next 3 years?
b. If the discount rate for the stock is 12%, at what price will the stock sell?
c. What is the expected stock price 3 years from now?
d. If you buy the stock and plan to sell it 3 years from now, what are your expected cash flows in (i) year 1; (ii) year 2; (iii) year 3?
e. What is the present value of the stream of payments you found in part (d)? Compare your answer to part (b).
Answer:
a. Expected dividend in next three years:
Dividend growth rate=4%=0.04
D1=Expected dividend next year=1*(1+0.04)=$1.04
D2=Expected dividend in year 2=D1*1.04=$1.0816
D3=Expected dividend in year3=D2*1.04=$1.124864
.b Discount rate=12%=0.12
Market price of the share=D1/(R-g)
R=Discount rate=0.12
g=Dividend growth rate=0.04
Market Price of Share=1.04/(0.12-0.04)=$13
.c. Expected stock price after three years=P3=D4/(R-g)
D4=D3*1.04=$1.169859
Stock price after 3 years=P3=1.169859/(0.12-0.04)=$14.62323
.d. (i)Cash flow in year 1= Dividend D1=$1.04
(ii)Cash flow in year2=Dividend D2=$1.0816
(iii)Cash flow in year 3 =D3+P3=1.124864+14.62323=$15.7481
.e. Present value of stream of cash flows=(1.04/1.12)+(1.0816/(1.12^2))+15.7481/(1.12^3)
Present value of stream of cash flows=$13.00
The amount is same as present market price of share calculated under .b ie $13
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