Question

Jedi Corp. common stock is expected to pay their first dividend of $2 at the end of two years from today. Once the firm starts paying dividends, analysts expect the dividends to grow at a supernormal rate of 8% for the next year, and then attain a constant growth of 2% forever thereafter. The firm’s beta is 1.2, the risk-free rate of return is estimated to be 4.5%, and the market risk premium is 2.5%. (Please explain without using excel)
a) What is the value of Jedi’s stock today?
b) WhatisthevalueoftheJediCorp.stockexpectedtobein2years,iftherequiredrateofreturn
on the stock remains constant?

Answer 1

Part A:

Stock Price = PV of CFs from it.

Div Calculation:

Year	Cash Flow	Formula	Calculation
1	$          -	Given	Given
2	$      2.00	Given	Given
3	$      2.16	D2(1+g)	2*1.08
4	$      2.20	D3(1+g)	2.16*1.02

Required Ret = Rf + Beta ( Rm - Rf)

Rf = Risk free ret
Rm = Market ret
Rm - Rf = Risk Premium
Beta = Systematic Risk

Particulars	Amount
Risk Free Rate	4.5%
Market Return	7.0%
Beta	1.2000
Risk Premium ( Rm - Rf)	2.50%

Beta Specifies Systematic Risk. Systematic risk specifies the How many times security return will deviate to market changes. SML return considers the risk premium for Systematic risk alone.Where as CML return considers risk premium for Total risk. Beta of market is "1".

SML Return = Rf + Beta ( Rm - Rf )
= 4.5 % + 1.2 ( 2.5 % )
= 4.5 % + ( 3 % )
= 7.5 %

Rf = Risk Free Ret

Price after 3 Years = D4 / [ Ke - g ]

= $ 2.20 / [ 7.5% - 2% ]

= $ 2.20 / 5.5%

= $ 40.06

Price Today:

Year	Cash Flow	PVF @7.5%	PV of CFs
1	$          -	0.9302	$          -
2	$      2.00	0.8653	$      1.73
3	$      2.16	0.8050	$      1.74
3	$   40.06	0.8050	$   32.25
Price Today			$   35.72

Price Today is $ 35.72

PVF for Year 1 = 1 / (1.075^1)

PVF for Year 2 = 1 / (1.075^2)

PVF for Year 3 = 1 / (1.075^3)

Part B:

Price after 2 Years= PV of Future CFs from it.

Year	Cash flow	PVF @7.5%	PV of CFs
3	$      2.16	0.9302	$      2.01
3	$   40.06	0.9302	$   37.27
Price after 2 Years			$   39.27

Price after 2 Years is $ 39.27

PVF = 1 / 1.075

As there is gap of 1 Year between Year2 and Year 3.