A company expects to pay a dividend of $0.50 per share in one year's time. Dividends will then grow at 10% a year for the following two years (years 2 and 3), and at 4% a year indefinitely after that. The cost of equity is 12%. What is the value of a share today (to the nearest cent)?

Correct answer: B) $6.91

Explanation

Dividends: year 1 0.500; year 2 0.550; year 3 0.605. Value at the end of year 3 = D4 / (Ke - g) = 0.605 x 1.04 / 0.08 = 7.8650. PV = 0.500/1.12 + 0.550/1.12^2 + (0.605 + 7.8650)/1.12^3 = $6.91 (exact discounting, rounded to the nearest cent). Applying 10% growth in perpetuity gives $25.00, and forgetting to discount the year 3 value gives $9.18.