Question

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:

$$8.29$, is the right answer.

Explanation:

Let's assume that, there are three stages of growth therefore three stage dividend discount formula is being used.

Dividend (D1) = 2

The negative growth is of 5%

$D1=2(1-0.05)=1.90$

The present value of D1 =2

$P(D1)=\frac{1.90}{1+0.1}=1.72$

$D2=1.95*0.95=1.85$

$P(D2)= \frac{1.85}{(1+.1)^{2}}$

$P(D2)=1.52$

SECOND PERIOD OF ZERO GROWTH FOR TWO YEARS

$D3=1.85 \\P(D3)= \frac{1.85}{(1+.1)^{3}}$

$P(D3)=1.38\\P(D4)=1.26$

THREE PERIOD IS CONSTANT GROWTH 6%

$D5=1.85(1+.06)=1.961 \\P(D5)= \frac{1.961}{(1+.1)^5} \\P(D5)=1.21 \\D6=1.961 \times 1.06==2.07 \\P(D6)=\frac{2.07}{(1.1)^6} \\P(D6)=1.17$

The equity values are = P(D1)+P(D2)+P(D3)+P(D4)+P(D5)+P(D6)

Equity values = $1.72+1.52+1.38+1.26+1.21+1.17=8.29$

Therefore, the current price will be $$8.29$