Question

c) Memories of the 2007-2009 financial crisis have made you more risk averse, doubling the risk premium you require to purchase a stock. Suppose that your risk premium before the crisis was 5 percent and that you had been willing to pay $421 for a stock with a dividend payment of $10 and expected dividend growth of 4 percent. Using the dividend discount model, with unchanged risk-free rate, dividend payment and expected dividend growth, what price (rounded to the nearest dollar) would you now be willing to pay for this stock?

Answer 1

Let the required return on stock before crises be x

421 = 10/(x-4%)

X = 6.38%

Risk free rate = 6.38% - Risk premium

= 6.38% - 5%

= 1.38%

New required rate of return = 1.38% + 10% = 11.38%

Price per stock = 10/(11.38%-4%)

= $135.50

Let the required return on stock before crises be x

421 = 10/(x-4%)

X = 6.38%

Risk free rate = 6.38% - Risk premium

= 6.38% - 5%

= 1.38%

New required rate of return = 1.38% + 10% = 11.38%

Price per stock = 10/(11.38%-4%)

= $135.50