Question

A company currently pays a dividend of $2.8 per share (D0 = $2.8). It is estimated that the company's dividend will grow at a rate of 23% per year for the next 2 years, and then at a constant rate of 5% thereafter. The company's stock has a beta of 1.3, the risk-free rate is 7.5%, and the market risk premium is 3.5%. What is your estimate of the stock's current price? Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

According to the Capital Asset Pricing Model(CAPM), the expected return on the security is based on the level of its risk. The formula of CAPM is

​ER=Rf​+β(ERm​−Rf​)

where,

ER =expected return of investment = required return(r)

Rf​ = risk-free rate

β = beta of the investment

(ERm​−Rf​) = market risk premium​

Putting values in the equation

ER = 7.5 + 1.3(3.5)

ER = 12% = r

Current dividend(D0) = $2.8

g = 23%

D1 = D0 * (1+g) = 2.8*1.23 = 3.44

D2 = D1 * (1+g) = 3.44*1.23 = 4.24

Growth rate after year 2 = 5%

According to constant growth model,

Price at year 2 =

= 4.24* (1.05) / (.12 - .05)

= 4.44 / .07

= $63.54

Stock's current price =

= 63.54 / (1+.12)^2

= $50.65