A company currently pays a dividend of $2.0 per share. It is estimated that the

Question

A company currently pays a dividend of $2.0 per share. It is estimated that the company's dividend will grow at a rate of 20% per year for the next 4 years, and that the dividend will grow at a constant rate of 7% thereafter. The company's stock has a beta of 1.5, the risk-free rate is 6%, and the market return is 12.5% a. What is your estimate of the company's stock price at the end of the year 4? b. What is your estimate of the company's stock price today? c. Now assume that the constant annual dividend growth rate after year 4 will be 0.0% (not 7%). All other info, as given above, is unchanged. What is your estimate of the company's current price (Po) under this new assumption of growth rate?

Please explain this step by step so that I may understand.

Explanation / Answer

Required rate of return = Risk free rate + beta * (Market return - Risk free rate)

= 6% + 1.5 * (12.5% - 6%)

= 15.75%

a. Stock price at the end of Year 4 = $4.15 * (1+7%) / (15.75%-7%)

= $50.75

b. Stock price today = $2.40/(1+15.75%) + $2.88/(1+15.75%)2 + $3.46/(1+15.75%)3 + $4.15/(1+15.75%)4 + $50.75/(1+15.75%)4

= $37.04

c. Stock price today = $2.40/(1+15.75%) + $2.88/(1+15.75%)2 + $3.46/(1+15.75%)3 + $4.15/(1+15.75%)4 + $4.15 * (1+0%) / [(15.75%-0%)(1+15.75%)4]

= $23.44

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