Question

You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $3.00 a share at the end of the year (D1 = $3.00) and has a beta of 0.9. The risk-free rate is 4.9%, and the market risk premium is 5.0%. Justus currently sells for $44.00 a share, and its dividend is expected to grow at some constant rate, g. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is P3 ?) Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

The price is computed as shown below:

= Dividend in year 4 / (required rate of return - growth rate)

required rate of return is computed as follows:

= risk free rate + beta x market risk premium

= 0.049 + 0.9 x 0.05

= 9.4% or 0.094

growth rate is computed as follows:

current price = dividend in year 1 / (required rate of return - growth rate)

$ 44 = $ 3 / (0.094 - growth rate)

(0.094 - growth rate) = $ 3 / $ 44

growth rate = 0.094 - ( $ 3 / $ 44 )

growth rate = 2.581818182% or 0.02581818182

Dividend in year 4 is computed as follows:

= Dividend in year 1 (1 + growth rate)³

= $ 3 x 1.02581818182³

= $ 3.238414465

So, the price will be computed as follows:

= $ 3.238414465 / (0.094 - 0.02581818182)

= $ 3.238414465 / 0.068181819

= $ 47.50 Approximately

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