Question

A company currently pays a dividend of $2.4 per share (D₀ = $2.4). It is estimated that the company's dividend will grow at a rate of 16% per year for the next 2 years, and then at a constant rate of 7% thereafter. The company's stock has a beta of 1.5, the risk-free rate is 7.5%, and the market risk premium is 3.5%. What is your estimate of the stock's current price? Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

First of All we have to calculate expected rate of return/cost of capital as per CAPM Model

As per CAPM   

​Ra​=Rf+βa​∗(Rm​−Rf)

where:

Ra​=Expected return on a security

Rf=Risk-free rate

Rm=Expected return of the market

βa=The beta of the security

(Rm​−Rf)=Equity market premium​

Now to slove this problem we have to use Two stage dividend discounting formula

For this we have to determine the values of the first two dividend payments made during first two years, based on the current dividend payment of D0=$2.4 per share and a growth rate of 16%.

D1= $ 2.4*1.16= $2.784

D2= $ 2.784*1.16= $ 3.229

Constant Growth rate in second stage = 7%

Further solution is in the following image

Hence the stock price will be $ 54.52.

Note :- if you need further explanation of any step or have any query then feel free to ask in comment section.