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Date Posted: 10:13:53 12/10/01 Mon
Author: Dr. D.
Subject: Re: "decayed" dividends problem
In reply to: Inna K. 's message, ""decayed" dividends problem" on 15:52:44 12/07/01 Fri

Sorry I didn't see this before the exam, but for the sake of students yet to come (Sorry - I just watched Dicken's Christmas Carol) - the problem is a standard non-constant dividend growth model problem with one twist - the expected growth rate is negative in the early years. Here are the inputs:

D1 = 0.92 x (1.20) = 1.104
D2 = 1.104 x (1.15) = 1.270
D3 = 1.270 x (1.10) = 1.397

Since the dividends grow at a 5% constant rate after this, we can use D3 to get P2

P2 = 1.397/(0.14 - 0.05) = 15.52

Therefore, the cash flows are

C01 = D1 = 1.104
C02 = D2 + P2 = 1.27 + 15.52 = 16.73

PV @ 14% = 13.84 (the difference is due to rounding)


> Please help me with this problem.
> "New competition in Karamazov Brothers’ market is
>going to have an impact on the growth in the firm’s
>dividends. A current dividend of $0.92 was paid
>yesterday by Karamazov Brothers, and this dividend
>is expected to increase by 20% in the first year.
>After that point, the growth in dividends is expected
>to
>“decay” to the firm’s long-run constant growth of 5%.
>Such a “decay” process is one in which dividend
>growth declines by 5 percentage points per year up to
>the point where the expected constant rate of
>dividend growth is reached. So, year 2 dividend will
>be 15 percent higher than year 1, year 3 dividends
>will be 10 percent higher and after year 3, dividends
>will grow by 5 percent forever. Assume investors
>in Karamazov Brothers require a rate of return of 14%.
>Calculate the current price of Karamazov
>Brothers stock."
> The dividends that I came up with are C1=1.104,
>C2=1.058, C3=12.818(1.012+11.806), so the
>price=10.434. The correct price is given as
>$13.89. Where did I make a mistake?

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