(Extra 1 point) 5. You are considering to buy stocks of a new firm NNN. The firm’s most recent dividend was $1 per share. The dividend payment is expected to increase by 20% in year 1, 10% in year 2 and year 3, afterwards 2% forever. Your required return is 10%. What is the maximum price you are willing to pay?

$17.18

Explanation:

D1=(1*1.2)=1.2

D2=(1.2*1.1)=1.32

D3=(1.32*1.1)=1.452

Value after year 3=(D3*Growth rate)/(Required rate-Growth rate)

=(1.452*1.02)/(0.1-0.02)

=18.513

Hence current value=Future dividend and value*Present value of discounting factor(rate%,time period)

=1.2/1.1+1.32/1.1^2+1.452/1.1^3+18.513/1.1^3

=$17.18(Approx).

$17.18.

Explanation:

The Gordon Multi-stage Discount Model should be used here to calculate the maximum price that should be paid for the stock of NNN. This model assumes that the company goes through different growth stages, and there comes a time, when the growth rate of it becomes constant. Under this model, each dividend along with the terminal value is discounted using required return, and then the results are added to get the stock price.

Year          Dividends            Discount Factor                Present value  

1                $1.2 (1 * 1.2)           (1 + .1)^(-1) = .909                  $1.0909

2              1.32 (1.2 * 1.1)          (1 + .1)^(-2) = .826                   1.0909

3             1.452 (1.32 * 1.1)       (1 + .1)^(-3) = .751                    1.0909    

Terminal value:

[(1.452 * 1.02) / .1 - .02] = 1.48104 / .08 = $18.513.

Discount this calculated perpetuity for three years to get terminal value:

⇒ 18.513 * (1 + .1)^(-3) = 13.909.

Add-up all the present values with the terminal value, and the resultant value will be the stock price:

⇒ 1.0909 + 1.0909 + 1.0909 + 13.909 = $17.18.

The maximum price that an investor would be willing to pay is $17.18.

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