Question

The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. How much should an investor be willing to pay for this stock today?

Answer 1

As per the Dividend Discount Model, the price of the stock is calculated by using the following formula

The Current Price of the Stock = D0(1 + g) / (ke – g)

Required Rate of Return (Ke)

As per CAPM Model, Required Rate of Return (Ke) = Rf + Beta(Rm – Rf)

= 10% + 1.50(14% - 10%)

= 10% + 6%

= 16%

Where, Last Year Dividend (D0) = $3.00 per share

Required Rate of return (Ke) = 16%

Dividend growth rate (g) = 10%

The Current Price of the Stock = D0(1 + g) / (ke – g)

= $3.00(1 + 0.10) / (0.16 – 0.10)

= $3.30 / 0.06

= $55.00 per share

“Therefore, the investor be willing to pay $55.00 per share for this stock today”