Empire Builders is in need of capital to finance its current expansion plans. For this, it has decided not to raise dividends for the next 4 years, maintaining them constant at $2 per share. Analysts expect the growth rate after that to be about 3% per year. If the investors expect a 9% rate of return on the stock, the market price of Empire Builders is ________.
Click on the arrows to vote for the correct answer
A. B. C. D.C
Since the dividends do not grow at a constant rate, you cannot directly apply the Dividend Discount Model valuation formula. However, note that 4 years from now, looking into the future, you will see a constant growth rate of 3% and the dividend 5 years from now will be $2 * 1.03 = $2.06. Therefore, the stock price 4 years from now, using the required rate of return of 9%, will equal P = 2.06/(9% - 3%) = $34.33. Thus, the current stock price equals $2*(1/1.09 + 1/1.09^2 + 1/1.09^3 +
1/1.09^4) + 34.33/1.09^4 = $30.80.
Note that you must be very careful about the time line. In the Dividend Discount Model valuation formula, the price at time t uses the dividend paid at time (t+1).
That's the reason we had to use the dividend paid in year 5 to calculate the price at the end of year 4.