Stock currently sell for $40a share. The stock paid a dividend of $2.50 a share,

Question

Stock currently sell for $40a share. The stock paid a dividend of $2.50 a share, and the dividend is expected to grow forever at a constant rate of 4%% a year. What stock price is expected 1year from now? What is the estimated required rate of return on stock? Stock currently sell for $40a share. The stock paid a dividend of $2.50 a share, and the dividend is expected to grow forever at a constant rate of 4%% a year. What stock price is expected 1year from now? What is the estimated required rate of return on stock?

Explanation / Answer

Required rate of return on stock is nothing but the cost of capital.

Ke=D1/P0+g

Ke

D1= Dividend that would be paid at the end of the year.

Here current dividend is given as$2.50 and is expected to grow at a rate of 4%, Hence dividend that would be paid at year end would be $2.50 * (1+0.04) as dividend is expected to grow at a rate of 4%. There D1 = $2.50 * 1.04 = $2.60

Substituting these values in the above said formula to arrive at the cost of capital.

Ke=$2.60/$40 + 0.04

Ke = .105 * 100 = 10.5%.

Now to arrive at the stock price expected one year from now is determined by using the formula as below:

Formula under MM model to arrive at the current market price is P0 = (D1+P1)/(1+Ke)

$40 = ($2.60+P1)/(1+.105)

$44.2= $2.60 + P1

P1= $44.2 - $2.60 =$41.60

Therefore the expected price of the stock one year from now is $41.60.

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