ABC Manufacturing pays dividends annually. Dividends have been growing 4% a year. Today is May 1, 2014. Its next dividend, to be paid 1 year from today, will be $1.20 per share. The company is involved in a research and development (R&D) program to develop a new widget. The results are expected in 1 year. The discount rate is 10%.
a. Scenario 1. It is May 1, 2015, and the company announces the new widget is a great success. ABC pays its previously announced $1.20 dividend and announces the 2016 dividend will be $2.50 per share. What will be the stock price on May 1, 2015, if dividends beyond 2016 are expected to grow at 6% in perpetuity?
b. Scenario 2. It is May 1, 2015, and the company announces that the widget program has been ended and that the next annual dividend will be $1.248, 4% larger than the dividend it just paid. What is the stock price May 1, 2016?
c. If the probability of success of the R&D (scenario 1) is 30%, what price would you expect the stock to be today?
d. Suppose you bought the stock for the price you calculated in part (c) and the research and development program is successful. What will be the 1-year rate of return on your investment? What will be the 1-year rate of return on your investment if t he R&D is not successful? What is the expected rate of return?