Question

Crisp Cookware's common stock is expected to pay a dividend of $1.75 a share at the end of this year (D₁ = $1.75); its beta is 0.7. The risk-free rate is 5.6% and the market risk premium is 4%. The dividend is expected to grow at some constant rate, g_L, and the stock currently sells for $80 a share. Assuming the market is in equilibrium, what does the market believe will be the stock's price at the end of 3 years (i.e., what is )? Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Step-1, Calculation of the Required Rate of Return (Ke) using CAPM Approach

As per Capital Assets Pricing Model (CAPM), The Required Rate of Return (Ke) is calculated by using the following formula

Required Rate of Return (Ke) = Rf + [Beta x Market Risk Premium]

= 5.60% + [0.70 x 4.00%]

= 5.60% + 2.80%

= 8.40%

Step-2, Calculation of the Dividend Growth Rate (g)

Using the Dividend Discount Model (DDM), the Cost of Equity (Ke) is calculated as follows

Cost of Equity (Ke) = [D1 / P0] + g

Here, we’ve Cost of Equity (Ke) = 8.40%

Dividend in Year 1 (D1) = $1.75 per share

Current Share Price (P0) = $80.00 per share

Therefore, the Cost of Equity (Ke) = [D1 / P0] + g

0.0840 = [$1.75 / $80] + g

0.0840 = 0.021875 + g

g = 0.0840 – 0.021875

g = 0.062125 or

g = 6.2125%

Step-3, Calculation of the Stock Price at the end of Year 3 (P3)

The Stock Price at the end of Year 3 (P3) = Current Share Price x (1 + g)³

= $80.00 x (1 + 0.062125)³

= $80.00 x 1.062125

= $95.86 per share

“Hence, the Stock Price at the end of Year 3 (P3) will be $95.86”