1. A company currently pays a dividend of $4 per share (D0 = $4). It is estimate

Question

1. A company currently pays a dividend of $4 per share (D0 = $4). It is estimated that the company's dividend will grow at a rate of 19% per year for the next 2 years, then at a constant rate of 7% thereafter. The company's stock has a beta of 1.8, the risk-free rate is 3.5%, and the market risk premium is 6%. What is your estimate of the stock's current price? Round your answer to the nearest cent.

2. Assume that the average firm in your company's industry is expected to grow at a constant rate of 5% and that its dividend yield is 7%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work that leads you to expect that its earnings and dividends will grow at a rate of 50% [D1 = D0(1 + g) = D0(1.50)] this year and 20% the following year, after which growth should return to the 5% industry average. If the last dividend paid (D0) was $1.75, what is the value per share of your firm's stock? Round your answer to the nearest cent. Do not round your intermediate computations.

Explanation / Answer

Hi,

Please find the detailed answers as follows:

Part A:

Step 1: Calculate Cost of Equity (CAPM)

Cost of Equity = Risk Free Rate + Beta*Market Risk Premium = 3.5 + 1.8*6 = 14.30%

Step 2: Calculate Stock's Current Price

D1 = 4*(1+.19)

D2 = 4*(1+.19)^2

Price at the End of P2 = 4*(1+.19)^2*(1+.07)/(.143 - .07)

Stock's Current Value = 4*(1+.19)/(1+.143)^1 + 4*(1+.19)^2/(1+.143)^2 + 4*(1+.19)^2*(1+.07)/(.143 - .07)*(1+.143)^2 = 72.05 or 72

Answer is 72.05 or 72.

Part B:

Step 1: Calculate Cost of Equity

Required Rate of Return = Dividend Yield + Growth Rate = 5% + 7% = 12%

Step 2: Calculate Stock's Current Value

D1 = 1.75*(1+.50)

D2 = 1.75*(1+.50)*(1+.20)

Price at the End of Year 2 = 1.75*(1+.50)*(1+.20)*(1+.05)/(.12 - .05)

Stock's Current Value = 1.75*(1+.50)/(1+.12)^1 + 1.75*(1+.50)^(1+.20)/(1+.12)^2 + 1.75*(1+.50)*(1+.20)*(1+.05)/(.12 - .05)*(1+.12)^2 = 42.28 or 42.3

Answer is 42.28 or 42.3

Thanks.

Thanks.

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