In order to buy back its own shares, XYZ, Inc. has decided to suspend its dividends for the next three years. It will resume its annual cash dividend of $3.00 per share in year 4 and year 5. Thereafter, its dividend payments will grow at an annual growth rate of 5 percent, forever. The required rate of return on the XYZ's stock is 14 percent. What should the firm's current share price be?

Price of stock = $21.512

Explanation:

The Dividend Valuation Model is a technique used to value the worth of an asset. According to this model, the worth of an asset is the sum of the present values of its future cash flows discounted at the required rate of return.

The price of the stock will the sum of the present value of the dividend receivable.

Year PV

4 3 * 1.14^ (-4) 1.776240832

5 3 * 1.14^ (-5) 1.558105993

6 and beyond

This will be done in two steps:

PV of div (in year 5 terms) = D * (1+g) / (r-g)

D - dividend in year 5, g - growth rate in dividend, r - rate of return

= 3 * (1.05) / (0.14-0.05) = 35

PV in year 0 terms = 35 * 1.14^ (-5) = 18.17790325

Price of stock = 1.77 + 1.55 + 18.177 = 21.512

Price of stock = $21.512