Question

Consider the following information which relates to a given company:

Item

2019 Value

Earnings Per Share

$6.84

Price Per Share (Common Stock)

$36.65

Book Value (Common Stock Equity)

$64 Million

Total Common Stock Outstanding

2.8 Million

Dividend Per Share

$4.08

Analysts expect that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 7% thereafter. In addition, it is expected that the risk of the firm, as measured by the risk premium on its stock, to increase immediately from 8.7% to 12%. Currently, the risk-free rate is 5%.

Required: (c) Determine the current required return for the firm's stock.

INPUT YOUR ANSWER AS A PERCENT ROUNDED TO 2 DECIMAL PLACES − FOR EXAMPLE: 28.41%.

Answer 1

Rate of return using CAPM(Capital Asset Pricing Model) is

Expected Rate of Return=Risk Free rate+beta of Stock*(Risk Premium)

So Current rate of return is 8.7%+5%=13.7%

Beta of Stock is assumed as 1 which otherwise means Stock is in tandem with market .(Market Fluctuations will affect Stock prices in the same pattern)

If Risk Premium increases from 8.5 %to 12% then

Expected rate of return on stock(Required return) will be 12%+5%=17%

Market Value as per Dividend Growth

(Current Market Price per Share=$36.65)

For First year When growth rate in dividend is 6%

Market Price per Share=Dividend(1+growth)/(Expected Rate of return -Growth)

=4.08(1+6%)/(17%-6%)

=39.32

Rate of return in first year is =Dividend(1+growth)/MPS

=4.08(1.06)/39.32

=10.99%

For Next 2 Years when growth in dividend is estimated as 8%

Market Price per Share=Dividend(1+growth)/(Expected Rate of return -Growth)

=4.08(1+0.08)/(0.17-0.08)

=48.96

Rate of return in Second year is =Dividend(1+growth)/MPS

=4.08(1.08)/48.96

=9%

For Third year and thereafter when growth in dividend is expected as 7%

Market Price per Share=Dividend(1+growth)/(Expected Rate of return -Growth)

=4.08(1+0.07)(0.17-0.07)

=43.66

Rate of return from third year onwards is =Dividend(1+growth)/MPS

=4.08(1.07)/43.66

=10%