Question

A business is expected to pay a dividend of $1.50 per share at the end of the year, and that dividend is expected to grow at a constant rate of 5% per year in the future. The company's beta is 1.50, the market return is 15%, and the risk-free rate is 1.50%. What is the current stock price?

Answer 1

First we will calculate the expected or required rate of return as per below:

Expected return = Risk free rate + Beta * (Market return - Risk free rate)

Given: Risk free rate = 1.5, Market return = 15, Beta = 1.50

Putting the given values in the above equation, we get,

Expected return = 1.5 + 1.50 * (15 - 1.50)

Expected return = 1.5 + (1.50 * 13.5)

Expected return = 1.5 + 20.25

Expected return = 21.75%

Now, as per Gordon model, share price is given by:

Share price = D1 / k -g

where, D1 is next years' dividend = End of the year dividend = $1.5 per share, k is the required rate of return = 21.75% and g is the growth = 5%

Now, we will calculate the share price by putting the values in the Gordon Model formula:

Share price = $1.5 / 21.75% - 5%

Share price = $1.5 / 16.75%

Share price = $8.96