A high-growth firm is expected to have a dividend growth of 15% for the next 2 years. It is then expected to stabilize at 5%. The firm has just paid a dividend of $1 and investors require a rate of return of 12%. The market price of the firm's stock is ________.
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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 2 years from now, looking into the future, you will see a constant growth rate of 5% and the dividend 3 years from now will be $1 * 1.15^2 * 1.05 = $1.39. Therefore, the stock price 2 years from now, using the required rate of return of 12%, will equal P = 1.39/(12% - 5%) = $19.86. Thus, the current stock price equals 1.15/1.12 + (1.15/1.12)^2 +
19.86/1.12^2 = $17.77.
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 3 to calculate the price at the end of year 2.