Question

KEF Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 20% for the next 3 years, after which competition will probably reduce the growth rate in earnings and dividends to 10% and its constant forever. The company’s last dividend, D , was $1.25, its beta is 1.20, the market risk is 14.00%, and the risk-free rate is 3.00%. What is the current price of the common stock?

Answer 1

Required return=risk free rate+Beta*market risk premium

=3+(1.2*14)=19.8%

D1=(1.25*1.2)=1.5

D2=(1.5*1.2)=1.8

D3=(1.8*1.2)=2.16

Value after year 3=(D3*Growth rate)/(Required return-Growth rate)

=(2.16*1.1)/(0.198-0.1)

=24.244898

Hence current price=Future dividend and value*Present value of discounting factor(rate%,time period)

=1.5/1.198+1.8/1.198^2+2.16/1.198^3+24.244898/1.198^3

=$17.86(Approx)