Question

Todd Mountain Development Corporation is expected to pay a dividend of $3 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The risk-free rate of return is 5%, and the expected return on the market portfolio is 17%. The stock of Todd Mountain Development Corporation has a beta of .75. Using the constant-growth DDM, the intrinsic value of the stock is_________.

Answer 1

Information provided:

Next year’s dividend= $3

Dividend growth rate= 8%

Risk free rate= 5%

Expected return on the market portfolio= 17%

Beta= 0.75

First, the required return on the stock is calculated with the help of the capital asset pricing model.

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

b= Stock’s beta

Ke= 5% + 0.75*(17% - 5%)

     = 5% + 9%

     = 14%.

The value of the stock is calculated using the constant growth dividend discount model.

It is computed using the below formula:

Price of the stock today=D1/(r-g)

where:

D1=next dividend payment

r=interest rate

g=firm’s expected growth rate

Value of the stock= $3/ 0.14 – 0.08)

                                  = $3/ 0.06

                                  = $50.

In case of any query, kindly comment on the solution.