Question

A financial analyst has been following Davis Inc., a new high-tech firm. He estimates that the current risk-free rate (r_F) is 6.25%, the market risk premium (r_M - r_F) is 5%, and the firm’s beta is 1.75. The current dividend just paid (D₀) is $1.00. The analyst estimates that the company’s dividend will grow at a rate of 25% this year, 20% next year, and 15% the following year. After three years the dividend is expected to grow at a constant rate of 7% a year. The analyst believes that the stock is fairly priced. What’s the horizon value (terminal value) of the stock at the end of year 3 for the constant growth period?

		$23.07
		$23.83
		$25.42
		$26.85

Using the information from above, calculate the current price of the stock.

		$15.62
		$17.21
		$18.53
		$19.83

Answer 1

Question 1

Option 1

Horizon value of the stock at the end of year 3 = dividend at the end of year 4/(required return-growth rate)

Required return=risk free rate+market risk premium*beta

=6.25+5*1.75=6.25+8.75=15%

Dividend at the end of year 4=dividend now*(1+growth rate of year 1)*(1+growth rate of year 2)*(1+growth rate of year 3)*(1+growth rate of year 4)=1*1.25*1.2*1.15*1.07=$1.84575

Hence horizon price at end of year 3=1.84575/(0.15-0.07)=1.84575/0.08=$23.07

Question 2

Option 3

Current price of the stock=present value of horizon price+present value of the dividend for three years

=23.07/(1.15)^3+1.725/(1.15)^3+1.5/(1.15)^2+1.25/(1.15)^1

=$15.17+1.13+1.13+1.09=$18.52=$18.53(approx.)