Answers to Chapter Review and Self Test Problems

8.1 The last dividend, D0, was $2. The dividend is expected to grow steadily at 8 percent. The required return is 16 percent. Based on the dividend growth model, we can say that the current price is:

Po = DX/(R - g) = Do X (1 + g)/(R - g) = $2 X 1.08/(.16 - .08) = $2.16/.08 = $27

We could calculate the price in five years by calculating the dividend in five years and then using the growth model again. Alternatively, we could recognize that the stock price will increase by 8 percent per year and calculate the future price directly. We'll do both. First, the dividend in five years will be:

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

8. Stock Valuation

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PART THREE Valuation of Future Cash Flows

The price in five years would therefore be: P5 = D5 X (1 + g)/(R - g) = $2.9387 X 1.08/.08 = $3.1738/.08 = $39.67

Once we understand the dividend model, however, it's easier to notice that:

P5 = Po X (1 + g)5 = $27 X 1.085 = $27 X 1.4693 = $39.67

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