Question

A company currently pays a dividend of $2.2 per share (D₀ = $2.2). It is estimated that the company's dividend will grow at a rate of 25% per year for the next 2 years, and then at a constant rate of 5% thereafter. The company's stock has a beta of 1.5, the risk-free rate is 8%, and the market risk premium is 3%. What is your estimate of the stock's current price? Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Step 1: Calculation of cost of equity using Capital Asset Pricing Model

Using Capital Asset Pricing Model

Cost of Equity Ke = Rf + b ( Rm – Rf )

Where,

Rf – Risk free return = 8%

b – Beta = 1.5

Rm – Expected return on market portfolio

Rm-Rf – Market risk premium = 3%

Cost of Equity Ke = 8+1.5*3

= 8+4.5

= 12.50%

Step 2: Computation of market price at the end of year 2 using Gordon Growth Model

P2 = D3 / (Ke – g)

Where,

P2 - Market price at the end of year 2 =?

D3 - Expected dividend in year 3 = 2.2*1.25^2*1.05 = 3.609375

Ke – Cost of equity = 12.5%

G – Growth rate in dividend = 5%

P2 = 3.609375/(.125-.05)

= 3.609375/.075

= $48.125

Step 3: Computing current share price by discounting the cashflow at required return

Year	Dividend	[email protected]%	Present Value (Cashflow*PVF)
1	2.7500	0.889	2.44
2	51.5625(2.2*1.25^2+48.125)	0.790	40.75

current share price = Cashflow*PVF

= 2.44+40.75

= $43.19