Valorous Corporation will pay a dividend of $2.00 per share at this year's end (at t = 1) and a dividend of $2.50 per share at the end of next year (at t = 2). It is expected that the price of Valorous' stock will be $50 per share after two years (at t = 2). If Valorous has an equity cost of capital of 8%, what is the maximum price that a prudent investor would be willing to pay for a share of Valorous stock today?

The maximum price that should be paid for one share of this stock today is $46.86

Explanation:

Using the dividend discount model, we can calculate the price/fair value of the stock today. The DDM bases the price of the stock on the present value of the expected future inflows from the stock in the form of dividends and terminal value. The discount rate used to discount the cash flows is the cost of equity or required rate of return on stock.

The price of this stock at time zero (t=0) will be,

Prcie = 2 / (1+0.08)  +  2.5 / (1+0.08)^2  +  50 / (1+0.08)^2

Price = $46.86

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