Question

Question 3 (25 marks/Equity Valuation) Mr. Fox Mulder plans to invest in the shares of a high-tech company, Satellite Building Inc (SBI). SBI has just paid a dividend of $30 per share and the management has indicated that it will increase the dividend payments by 20% per year for the next three years, and 10% per year thereafter. SBI has a beta of 1.5. The long-term risk-free interest rate is 4% and the expected market return is 9%. (a)​Based on Capital asset Pricing Model (CAPM), compute the required rate of return on SBI ​shares. [Hint: Refer to the notes for the topic Risk, Return and CAPM.]​​ (b)​Using the answer in (a), calculate the market value per share of SBI. How much should Mr. Mulder pay for 100 shares?​​​ ​ ​​​​ (c)​If Mr. Mulder decides to sell all of SBI shares after 4 years, ​(i)​how much will he expect to get by selling the shares?​​​​ ​(ii)​how much will he have in total? Assume that the dividends are reinvested at the required rate of return calculated in (a).​​​ ​​​​

Answer 1

a)

As per CAPM, required rate of return (r) = Rf + beta x (Rm - Rf)

Rf= riske free rate of return = 4%

Rm=Market rate of return =9%

beta=1.5

r = Rf + beta x (Rm - Rf) = 4% + 1.5 x (9% - 4%) = 11.50%

b)

	Current year	Year 1	Year 2	Year 3	Perpetuity
Growth,g	0	20%	20%	20%	10%
Required Rate of Return (r)=	11.50%	11.50%	11.50%	11.50%	11.50%
Expected Dividend	30	36.00	43.20	51.84	57.02
PV of Dividends	26.91	28.96	31.16	33.54

Stock Price in year 3, P3 = D4 / (r - g) where, D4 - Dividend in year 4

P3=	3801.33
PV of Stock Price	2205.78
Current Value of Stock=PV of Stock Price + PV of Dividends	2326.34

Market Value of per share = 2326.34

For 100 shares he will have to pay $232634

c) Dividend in year 4 from above table = 57.02

Dividend in year 5 = 57.02 * (1+10%) = 62.73

Stock Price in year 4, P4 = D5 / (r - g) where, D5 - Dividend in year 5

P4 = 62.73/(11.5%-10%) = 4181.76

When he sells 100 shares after 4 years he will have $418176