The board of directors of API, a relatively new electronics manufacturer, has de
ID: 2764316 • Letter: T
Question
The board of directors of API, a relatively new electronics manufacturer, has decided to beginning paying a common stock dividend to increase the attractiveness of the stock in the free market. The board plans to pay $2.45 per share in the coming year (i.e., next year) and anticipates that its future dividends will increase at an annual rate consistent with that experienced over the period from 2009 - 2012 (see below). The company currently has a beta of 1.5, the rate of return for the market is expected to be 8% and the risk-free rate is currently 3%. Given this scenario, what is the current value of API's common stock? If the current market price is $48.00 per share, should you purchase this stock. Briefly, explain your answer. (HINT: This problem requires a three-part calculation to solve it). USE MS EXCEL TO CONDUCT YOUR CALCULATIONS (do NOT round your interim calculations, rather use links between the cells), then post your spreadsheet using this link (click on "Textbook Assignment 2," above).
Year Dividend
2012 $2.32
2011 $2.21
2010 $2.10
2009 $2.00
Explanation / Answer
Step 1: Calculate Annual Growth Rate
The annual growth rate can be calculated as follows:
Growth Rate = (Dividend in Year 10 - Dividend in Year 2009)/Dividend in Year 2009*100 = (2.10 - 2)/2*100 = 5%
Growth rate is same for all the years. Ir can be verified by performing calculations as follows:
Dividend Year 2010 = 2*(1+5%)^2 = $2.21
Dividend Year 2011 = 2*(1+5%)^3 = $2.32
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Step 2: Calculate Cost of Capital/Discount Rate
The cost of capital can be calculated with the use of CAPM formula as follows:
Cost of Capital = Risk Free Rate + Beta*(Market Return - Risk Free Rate) = 3% + 1.5*(8% - 3%) = 10.50%
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Step 3: Calculate the Current Price of the Stock
The current price of the stock is calculated with the use of following formula:
Current Price of the Stock = Next Year Dividend/(Cost of Capital - Discount Rate) = 2.45/(10.50% - 5%) = $44.55
If the current stock price is $48, you shouldn't purchase the stock as it is overvalued. You should buy the stock at a price of $44.55 as calculated above.
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