Muscle motors, a car company specializing in vintage, retro cars just paid a div

Question

Muscle motors, a car company specializing in vintage, retro cars just paid a dividend on its common stock of $1.65/share. The required return of the company’s common stock can be calculated using the Capital Asset Pricing Model and the following information: market risk premium: 6%, beta = 1.35, risk free rate 5.4% a. What is Muscle motor’s cost of equity capital? b. Calculate the price of its common stock if dividends grow at 0% per year. c. Calculate the price of its common stock if dividends grow at an annual rate of 4.5% d. Calculate the price of its common stock if dividends grow at an annual rate of 6.5% for the first three years, followed by 3.5% annual growth thereafter.

Explanation / Answer

a) Cost of equity as per CAPM = Risk free rate+Beta*Market risk premium = 5.4+1.35*6 = 13.50 % b) Price of common stock with 0% dividend growth rate = Dividend/Required return = 1.65/0.135 = $          12.22 c) Price with a constant growth rate of 4.5% = 1.65*1.045/(0.135-0.045) = $          19.16 d) Price under the two stage growth model: PV of dividends for the first three years = 1.65*1.065/1.135+1.65*1.065^2/1.135^2+1.65*1.065^3/1.135^3 = $            4.36 Continuting Value of dividend at t3 = 1.65*1.065^3*1.035/(0.135-0.035)= $           20.63 PV of continuing value = 20.63/1.135^3 = $          14.11 Price of the share $          18.47

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