The following data pertains to a common stock: * It will pay no dividends for two years. * The dividend three years from now is expected to be 1. \* Dividends are expected to grow at a 7% rate from that point onward. If an investor requires a 17% return on this stock, what will they be willing to pay for this stock now? A) 6.24. B) 7.30. C) 8.26. D) $10.00. Your answer: B was correct! time line = $0 now; $0 in yr 1; $0 in yr 2; $1 in yr 3. P2 = D3/(k - g) = 1/(.17 - .07) = $10 Note the math. The price is always one year before the dividend date. Solve for the PV of $10 to be received in two years. FV = 10; n = 2; i = 17; compute PV = $7.30 ----------------- I tried to do samething little different, but did not get same value. I have calculated value of stock at year 3. So, p3 = d4/k-g = d3(1+g)/k-g = 1*1.07/.17-.07 = 10.7 Then calculated PV FV= 10.7 , n=3, i=17; compute pv = -6.68 I did not understand why I got different value. What is my mistake?
simple oversight. You calculated the stock’s terminal value at t3 but forgot the actual dividend paid that year (i.e. $1). Go ahead and add $1 / 1.17^3 = $0.62437 to your answer and you get about $7.3 (= 6.68 + 0.62437). The easiest way to solve DDM questions quickly on the exam is to use your calculator’s cash flow worksheet. I assure you incorrect responses on DDM questions will exactly match what you’ll calculate by omitting this detail and other common mistakes.
Take into account the dividend you recieve in year 3, $1. Discount that back (1/1.17^3) and you'll get around .62, which is the difference between $7.30 and $6.68.
Appreciate for quick replies. Now I understood.