Question

McGaha Enterprises expects earnings and dividends to grow at a rate of 25% for the next 4 years, after the growth rate in earnings and dividends will fall to zero, i.e., g = 0. The company's last dividend, D ₀, was $1.40, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the current price of the common stock?

Answers:	a. $29.23
	b. $30.21
	c. $27.89
	d. $26.09
	e. $31.42

Answer 1

Answer is $29.23

Required Return, r = Risk-free Rate + Beta * Market Risk Premium
Required Return, r = 4.00% + 1.20 * 5.50%
Required Return, r = 10.60%

D0 = $1.40

Growth rate for next 4 years is 25%

D1 = $1.4000 * 1.25 = $1.7500
D2 = $1.7500 * 1.25 = $2.1875
D3 = $2.1875 * 1.25 = $2.7344
D4 = $2.7344 * 1.25 = $3.4180

Annual Dividend after Year 4 = $3.4180

Stock Price at the end of Year 4 = Annual Dividend / Required Return
Stock Price at the end of Year 4 = $3.4180 / 0.1060
Stock Price at the end of Year 4 = $32.2453

Current Stock Price = $1.75/1.1060 + $2.1875/1.1060^2 + $2.7344/1.1060^3 + $3.4180/1.1060^4 + $32.2453/1.1060^4
Current Stock Price = $29.23

So, current price of the common stock is $29.23