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Suppose that the 1-year effective risk-free interest rate is 3%. Consider a stock that pays annual dividends. The stock is expected to pay a $2.0 dividends per share in one year. The dividends are expected to remain constant at $2.0 per share for the next four years (years 1, 2, 3 & 4). After year 4, the dividends are expected to increase at the rate of 2% for the next three years. After seven years, the dividends are expected to remain the same forever, i.e., the dividend growth rate after seven years is zero.
(a) Find the fair value of the stock today, if the annual cost-of-capital is 14%.
(b) If the expected dividends are risk-free, what will be the fair value of the stock today?
(c) How much extra price do you pay for the risky dividends?
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