ABC company's common stock just paid its annual dividend of $5 per share. The required return on the common stock is 10%. Dividends are expected to grow yearly at 3% for the next four years, followed by a constant annual growth rate of 2% in years 5 to infinity. Estimate the value of the common stock.

Answer rating: 100% (QA)

To estimate the value of the common stock we can use the dividend discount model DDM which calculates the present value of future dividends Heres how we can approach this 1 Determine the dividend payments for the next four years Year 1 dividend 5 Year 2 dividend Year 1 dividend 1 growth rate 5 1 3 515 Year 3 dividend Year 2 dividend 1 growth rate 515 1 3 530 Year 4 dividend Year 3 dividend 1 growth rate 530 1 3 545 2 Calculate the present value of the dividends for years 1 to 4 using the required return PVYear 1 dividend Year 1 dividend 1 required return1 PVYear 2 dividend Year 2 dividend 1 required return2 PVYear 3 dividend Year 3 dividend 1 required return3 PVYear 4 dividend Year 4 dividend 1 required return4 3 Estimate the value of the stock in year 4 which is the value of all future dividends beyond year 4 Value in year 4 Year 4 dividend required return growth rate 4 Calculate the present value of the value in year 4 PVValue in year 4 Value in year 4 1 required return4 5 Sum up the present values of the dividends and the value in year 4 to get the estimated value of the common stock Estimated value PVYear 1 dividend PVYear 2 dividend PVYear 3 dividend PVYear 4 dividend PVValue in year 4 Plugging in the numbers PVYear 1 dividend 5 1 101 PVYear 2 dividend 515 1 102 PVYear 3 dividend 530 1 103 PVYear 4 dividend 545 1 104 Value in year 4 545 10 2 PVValue in year 4 Value in year 4 1 104 Finally calculate ... View the full answer