Question

2. You are considering the purchase of a stock that just paid a dividend of $6.00. You expect this stock to have a growth rate of 20 percent for the next 2 years, and a long-run normal growth rate of 8 percent thereafter. The risk free- rate is 2 percent, the return on the market is 10 percent, and the company has a beta of 1.2. What is the maximum price you should be willing to pay for this stock?

Answer 1

Requirred rate of return = RF + Beta * (RM - RF) = 2 + 1.2*(10-2) = 11.6%

Maximum price willing to pay now = $ 221.50

1		2	3
Year	Dividen	Dividend	PVF@ 11.6%	PV P1 (2*3)
1	6*1.2^1	7.20	0.8961	6.4516129
2	6*1.2^2	8.64	0.8029	6.93721818
2	price at 2	259.20	0.8029	208.11168
				0
Total		221.500511
price at year 2 =	Dividend 2 * (1+G)/ (Ke-G)
		(8.64*1.08 )/( 0.116-0.08)
		259.2

NOTE:

PV @ 11.6% = 1/1.116^n where n is years