Question

You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $1.75 a share at the end of the year (D₁ = $1.75) and has a beta of 0.9. The risk-free rate is 4.9%, and the market risk premium is 4%. Justus currently sells for $27.00 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 ?) Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Cost of equity=risk free rate+(beta*market risk premium)=4.9%+(0.9*4%)=8.5%

Now we have to find the constant growth rate,g. the formula is g=Cost of equity-(D1/Share price)=8.5%-(1.75/27)=8.5%-6.48%=2.02%

Value of the Stock price at the end of 3 years=D4/(Cost of equity-growth rate)

D2=D1*(1+g)=1.75*(1+2.02%)=$1.785

D3=D2*(1+2.02%)=$1.785*(1.0202)=$1.821

D4=D3*(1+2.02%)=$1.821*(1.0202)=$1.858

Value of the Stock price at the end of 3 years=1.858/(8.5%-2.02%)=$28.67