Question

You are considering an investment in a stock, which is expected to pay a dividend of $1.50 a share at the end of the year (D₁ = $1.50) and has a beta of 0.9. The risk-free rate is 2.6%, and the market risk premium is 6.0%. The company currently sells for $39.00 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 ?) Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

As per Constant growth rate model of share valuation,

Cost of Equity [Ke] P0 = [D1/Po] + g

Here, We have Po = $39 per share

D1 = $1.50 per share

Cost of Equity [Ke] is calculated by using the Capital Asset Pricing Model[CAPM] Approach

As per CAPM Model, Cost of Equity [Ke] = Rf + B[Rm-Rf]

= 2.60% + [6% x 0.90]

= 2.60% + 5.40%

= 8%

If the market is in equilibrium, then the Market Price of the Stock will be the future value of the current market price

Therefore, The Stock Price at the end of Year 3 = P0 x [1 + Ke]³

= $39 x [1+0.08] ³

= $39 x 1.25971

= $49.13

“Hence, The Stock Price at the end of Year 3 = $49.13”