Composite Software, Inc. is anticipated to experience temporary supernormal growth of 40% per year for the next two years. After this supernormal growth period has passed, the growth rate of Composite Software is anticipated to experience a two-year transition phase of 25% per year growth. Following this transition phase, the growth rate of Composite Software is expected to stabilize at 15% annually. The Company currently pays a dividend of $0.10 per share, and the required rate of return is 18% per year. What is the value of Composite Software common stock?
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To determine the value of a common stock experiencing temporary supernormal growth, use the following equation:
{V = {[d0 * (1 + gs)^1] / k} + {[d1 * (1 + gs)^2} + ... {dn * (1 + gs)^n} + {[dn * (1 + gs)^n * (1 + gn] / (k - g)}/ (1 + k)^n}}
Where: V = the value of common stock at t0, d0 = the dividend at t0, d1 = the dividend at t1, dn = the dividend at tn, gs = the supernormal rate of growth, gn = the normal rate of growth, n = the time period "n", and k = the required rate of return.
In this example, there is a transitional growth period of two years, during which the growth rate of Composite Software is expected to grow at 25% annually. This period will follow the two-year supernormal growth period, and would be denoted as g subset t. The calculation of the value of this common stock is illustrated as follows:
{V = {[$0.10 * (1.40)^1] / (1.18)} + {[$0.10 * (1.40)^2] / (1.18)^2} + {[$0.10 * (1.40)^2 * (1.25)^1] / (1.18)^3} + {[$0.10 * (1.40)^2 * (1.25)^2] / (1.18)^4} + {{[$0.10 *
(1.40)^2 * (1.25)^2 * (1.15)^1]/ (0.18 - 0.15)}/ (1.18)^4}
Which can be deduced to the following series of discounted cash flows:
{V = [$0.118644 + $0.140764 + $0.149115 + $0.15796 + $6.055146] = $6.62}