Answer:
PHASE 1
Growth rate (g) = 10% = 0.10
No of years (n) = 2 years
Cost of equity (Ke) = 15% = 0.15
Current dividend paid (Do) = $2
Dividend in 1 year’s time (D1) = Do(1+g)n
= $2(1 + 0.10)1
= $2.20
Dividend in 2 year’s time (D2) = Do(1+g)n
= $2(1 + 0.10)2
V1 = D1 + D2
(1 + K) (1 + K)2
V1 = $2.20 + $2.42
(1 + 0.15) (1 + 0.15)2
V1 = 2.20 + $2.42
1.15 1.15)2
V1 = $1.9130 + $1.8297
V1 = $3.7427
PHASE 2
g = 7% = 0.07
V2 = DN( 1 + g)
(Ke –g)(1+ K)n
V2 = $2.42(1 + 0.07)
(0.15 – 0.07)(1+ 0.15)2
V2 = $2.5894
(0.08)(1.15)2
V2 = $2.5894
(0.08)(1.3225)
V2 = $24.4745
Current market price = V1 + V2
= $3.74 + $24.47
= $28.21
The correct answer is B
Explanations:
In this case, there is need to calculate the current market price of equity in the first growth regime of 10%. The current market price is a function of dividend in 1 year’s time and dividend in year’s time divided by (1 + Ke)n.
In the second phase of growth, the growth rate is 7%. We need, to determine the current market price , which is a function of dividend in 2 year’s time, subject to the new growth rate divided by the product of K-g and (1+ K)n.
The current market price is the aggregate of market prices for the two growth regimes.
