Question

Consider the following information which relates to a given company: Item 2019 Value Earnings Per Share $6.17 Price Per Share (Common Stock) $42.81 Book Value (Common Stock Equity) $63 Million Total Common Stock Outstanding 2 Million Dividend Per Share $3.91 Analysts expect that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 7% thereafter. In addition, it is expected that the risk of the firm, as measured by the risk premium on its stock, to increase immediately from 8.7% to 11%. Currently, the risk-free rate is 5%. Required: (d) Determine the new required return for the firm's stock.

Answer 1

In the above problem, given are,

D0=$3.91, Growth of first 2 years is 8% and constant growth of 7% thereafter.

Here D1=expected dividend=D0*(1+g) or, 3.91*(1+0.08) or, $4.22; D2=D0(1+0.08)^2 or, $4.56 &

D3=D2*(1+0.07) or, $4.88

We know that, P0=D1/(Ke-g) where Ke=11% or 0.11 & g(constant growth rate)=7% or 0.07

From the above formuale we can say that, P2=D3/(0.11-0.07) or, P2=4.88/0.04 or, $ 121.99

Now intrinsic value of the share will be, D1/(1+Ke)^1+D2/(1+Ke)^2+P2/(1+Ke)^2

If we put the values and solve the equation we will get the value of share to be $ 106.52

The new required return should be risk-free rate+risk premium on its stock i.e. (5%+11%) i.e. 16%.