Question

Your firm has a beta of 1.3, a current stock price of $55, and you just paid a dividend of $1.25. You are considering a new project that would raise your beta to 1.6. If the risk-free rate is 2% and the expected market return is 6%, what growth rate must the new project have to make it feasible?

Answer 1

Using CAPM,

Required return on Equity (Ke) = Risk Free Rate + Beta x Market Risk Premium

Required return on Equity (Ke) = 2% + 1.3 x (6%-2%)

Required return on Equity (Ke) = 7.2%

Stock Price (P0) = $55

Dividnd (D0) = $1.25

According to Gordon's Dividend Growth model,

Stock price = D0 x (1+g) / (Ke-g)

55 = 1.25 x (1+g) / (0.072 - g)

55 x (0.072-g) = 1.25 + 1.25g

3.96 - 55g =1.25 +1.25g

2.71 = 56.25g

g = 4.8178%

Therefore, new project must have growth rate of 4.82% to be feasible.