Quick question for current bankers:
Company X announced a dividend of $0.50 per share as well as their decision to reduce dividend payments for the next 5 years due to an expansion project. They expect a decline in the dividend of about 2% per year for 5 years. After 5 years, the project will be completed and the growth rate will go up to 7% per year for the next 5 years (starting with D6 and ending with D10). Then the growth rate will fall down to 3% indefinitely (starting with Year 11). If the required rate of return is 7%, what is the current price per share for SPIC, Inc.?"
Here's my question: after 5 years, the growth rate of 7%= the discount rate at 7%. My finance book says under these conditions, I cannot use the "dividend growth model" (since the denominator is clearly 0) but does not propose an alternative. I was planning on using the two stage growth model but am not sure what to do anymore.
How do you guys approach these situations in real life (and if the growth rate exceeds the discount rate) and how do I proceed in solving this problem? Is this problem realistic in the financial world? Thanks!
Maybe I read this wrong, but I don't think Cash Flows 6 - 10 can be used with the dividend growth model. That is used primarily for perpetuities CF / (k-g) What you want to do is manually grow the dividend in the denominator and discount it at 1.07^t. After year 10, then you can use the dividend growth model to estimate the continuing (terminal) value. For your other question regarding the growth rate exceeding the discount rate, this situation cannot exist in perpetuity for obvious reasons. In essence, the value of the company will be infinity (as it is growing faster then the economy) and you will be implying that the company actually will become the econonmy.
do your own homework
seriously lol
Thanks--that clarifies much of my confusion.
One question: What do you mean by growing the dividend in the denominator?
they meant numerator..... set up your model to have the actual dividend calculated for years 1-10 and discount these back by the required rate..... with year 11 being the perpetuity in which case your growth rate is below the required rate of return so everything is fine then.
I did mean numerator. Apologies. If it is growing at 7%, multiply the past dividend by 1.07 and so on. So
D0 = x D1 = x(1+g) / 1+r D2 = x(1+g)^2 / (1+r)^2 or you can use D1(1+g) / (1+r)^2
companies reduce dividends as a last resort and would most likely issue debt to fund the project
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