Question

Vasudevan Inc. forecasts the dividend per share shown below. If the T-bond rate is 3.25%, firm beta is 1.15, the market risk premium is 11%, and the dividends are expected to continue growing at the same rate after Year 5 as from Year 3 to Year 4, what is the stock price today?

Year	1	2	3	4
Dividend	$0	$0	$4.20	$4.5

Answer 1

As per CAPM,

Cost of Equity = Risk free rate + beta x market risk premium

Cost of Equity (k_e)= 3.25% + 1.15 x 11% = 15.90% p.a.

Growth rate for year 4 = 4.50/4.20 - 1 = 7.1429%

Therefore, growth rate after year 4 (g) = 7.1429%

Therefore, Terminal value of future dividends at the end of year 4 = D₅ / (k_e - g)

Terminal value of future dividends at the end of year 4 = D₄ (1+g) / (k_e - g) = 4.50 (1+7.1429%) / (15.90% - 7.1429%)

Terminal value of future dividends at the end of year 4 = $ 55.06

Stock price = PV of future dividends

PV of Future dividends:

Year	Dividend	Discounting factor @ 15.90%	Present Value
1	-	0.863	-
2	-	0.744	-
3	4.20	0.642	2.70
4	4.50	0.554	2.49
(Terminal Value) 4	55.06	0.554	30.51
	Value of stock		35.71

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