Question

Best Foods Corp. expects earnings and dividends to grow at a rate of 25% for the next 4 years. After that period, the growth rate in earnings and dividends will fall to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock?

Answer 1

Solution:
Given:
Dividend Growth rate upto next 4 Years	Growth rate = 25%
There after Growth rate	Growth rate = 0
Last Dividend i.e D0	$1.25
Beta	1.2
Market risk Premium	5.50%
Risk free rate	3%
We would first calculate the Return by using the CAPM Method:
Ke = Risk free rate + (Beta*Market Risk Premium)
3%+(1.2*5.5%)
0.096 i.e 9.6%
Ke i.e Expected return = 9.6%
Year	Dividend	Working	Discounting factor @ 9.6%	Working	Present value
	a		b		c = a*b
1	1.5625	($1.25*1.25)	0.912408759	(1/1.096^1)	1.425638686
2	1.953125	($1.5625*1.25)	0.832489744	(1/1.096^2)	1.625956531
3	2.44140625	($1.953125*1.25)	0.759570934	(1/1.096^3)	1.854421226
4	3.051757813	($2.44140625*1.25)	0.693039173	(1/1.096^4)	2.114987712
5	3.051757813	(As growth rate = 0)
We will first find Price at the end of 4 th year
Price 4 = D5/Ke-g
$3.051757813/9.6%-0
31.7891
Price at the end of year 4 = $31.7891
To calculate price today = Price at the end of year 4 *Discounting factor of 4 th year
$31.7891*0.693039173
22.03109157
Current price of common stock = $22.03