The high “supernormal” growth in the first three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and finite dividend growth models (DDM) to value the stock.

Step 1: Determine the dividend stream through year 4

• D₁ = $2.00 (given)
• D₂ = D₁ × (1 + g) = 2.00 × (1.25) = $2.50
• D₃ = D₂ × (1 + g) = $2.50 × (1.25) = $3.13
• D₄ = D₃ × (1 + g) = $3.13 × (1.08) = $3.38

Step 2: Calculate the value of the stock at the end of year 3 (using D₄)

• P₃ = D₄ / (k_e – g) = $3.38 / (0.15 – 0.08) = $48.29

Step 3: Calculate the PV of each cash flow stream at k_e = 15%, and sum the cash flows. Note: We suggest you clear the financial calculator memory registers before calculating the value. The present value of:

• D₁ = 1.74 = 2.00 / (1.15)¹, or FV = -2.00, N = 1, I/Y = 15, PV = 1.74
• D₂ = 1.89 = 2.50 / (1.15)², or FV = -2.50, N = 2, I/Y = 15, PV = 1.89
• D₃ = 2.06 = 3.13 / (1.15)³, or FV = -3.13, N = 3, I/Y = 15, PV = 2.06
• P₃ = 31.75 = 48.29 / (1.15)³, or FV = -48.29, N = 3, I/Y = 15, PV = 31.75
• Sum of cash flows = 37.44.
• Thus, the stock is undervalued by 37.44 – 31.00 = approximately 6.40.

Note: Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that the question asks you to select the closest answer.