Question

Avocado Incorporated just paid a dividend of $3. An analyst expects this dividend to grow at a rate of 12% for the next 3 years. After this initial growth stage, the firm is expected to grow at a rate of 5% forever. The required return on this stock is 8%. Given the analyst’s projections, what is the most you should pay for this stock? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)

Answer 1

Answer:

The most you should pay for this stock is 126.89

Explanation:

The dividend in years 1 – 3 will grow at 12% and then at 5% forever.  

We had to get the PV for the dividends in years 1-3 (year 3 also includes the estimated future value of the stock).

We used our calculators to find the PV of each year at the 8% discount rate.  Finally we will add them all together to get the final answer.

We find the future dividends using g =12%

Dividend in year 0 --->

Dividend in year 1 ---> 3.36

Dividend in year 2 ---> 3.76

Dividend in year 3 ---> 4.21

Dividend in year 4 ---> 4.43

Now we will calculate the present value of the future dividends using r = 8%

Stock Value assuming constant growth rate  = 147.52 --(a)

PV in year 1 ---> 3.11

PV in year 2 ---> 3.23

PV in year 3 ---> 120.45  --(discounting (a))

= 120.45 + 3.23 + 3.11

= 126.89