I know the answer now. But I can’t understand it. Could someone just explain it to me?
Bybee is expected to have a temporary supernormal growth period and then level off to a “normal,†sustainable growth rate forever. The supernormal growth is expected to be 25 percent for 2 years, 20 percent for one year and then level off to a normal growth rate of 8 percent forever. The market requires a 14 percent return on the company and the company last paid a $2.00 dividend. What would the market be willing to pay for the stock today?
In general with these problems, remember that the value of the stock at time T is the present value of all the expected cash flows in the years after T…T+1, T+2…
First off, sorry I dont have a calculator nearby. You said you were able to calculate the answer, so maybe my numbers aren’t so important as are the explanations.
D1 is expected to be D0*(1+25%)= 2*(1.25)
D2= D1*1.25 (25% growth from D1)
D3= D2*1.20 (20% growth from D2)
D4= D3*1.08 (8% growth from D3) and every year after year 4, the dividend will grow by 8%, now we have a constant growth rate.
So discount D1, D2, and D3 to present value since they are supernormal growth dividends. Sum these and hold on to this number.
Now, what is the value of the stock at the end of year three (after super growth, what would someone pay for the future dividends)? Well, it can be found using the gordon model.
So price at end of year 3 (P3)= D4/(k-g) = [D3*1.08]/[.14-.08]
BUT this is the value of the stock, three years from today. So discount it by saying P3/[(1.14)^3] and add it to the other discounted cash flows.
I recommend making a quick timeline to clearly illustrate what is occuring at what time.
I always understood the DDM such that we are able to use the first dividend that will grow at the constant rate, in this case, D3 ($3.75) to calculate the price at t=2. I never had to calculate D4 in my solution.
