According to the prospectus of New Start Ltd, the company anticipates paying its first dividend of $0.85 in 4 years time, and thereafter expects the dividend to increase by 4% each year indefinitely. If the required return is 15%, what is the current value of a New Start share today? Group of answer choices $4.42 $5.67 $7.73 $5.28 $5.08
Question
According to the prospectus of New Start Ltd, the company anticipates paying its first dividend of $0.85 in 4 years time, and thereafter expects the dividend to increase by 4% each year indefinitely. If the required return is 15%, what is the current value of a New Start share today?
Group of answer choices
$4.42
$5.67
$7.73
$5.28
$5.08
Solution
To calculate the current value of a New Start share today, we need to use the Gordon Growth Model (also known as the Dividend Discount Model). This model is used to determine the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate.
The formula for the Gordon Growth Model is:
P = D / (r - g)
where: P = price of the stock D = expected dividend in one year r = required rate of return g = growth rate of dividends
In this case, the company expects to pay its first dividend of $0.85 in 4 years, and expects the dividend to increase by 4% each year indefinitely. The required return is 15%.
However, since the first dividend is not paid in the first year, we need to calculate the present value of the price we get from the Gordon Growth Model 4 years from now.
First, calculate the expected dividend in one year from now (which is actually 4 years from now):
D = 1.00
Then, plug the values into the Gordon Growth Model:
P = 10.00
Finally, calculate the present value of this price, discounted back 4 years at the required rate of return:
P = 5.67
So, the current value of a New Start share today is $5.67.
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