Question

McGaha Enterprises expects earnings and dividends to grow at a rate of 17% 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, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? Select the correct answer.

Answer 1

If the dividend and the growth rate will fall to zero after 4 years, the share price of the share will be the present value of the dividends received in these 4 years.

According to Gordon's formula for super normal growth:

Share Price = Div * (1+g)1/(1+Ke)1 + Div * (1+g)2/(1+Ke)2 + Div * (1+g)3/(1+Ke)3 + Div * (1+g)4/(1+Ke)4

Div = $1.25

g = 17%

Ke = Risk free rate + (beta * market risk premium) = 3% + (1.2 * 5.5%) = 6.8%

Putting the values in the formula:

Share Price = Div * (1+g)1/(1+Ke)1 + Div * (1+g)2/(1+Ke)2 + Div * (1+g)3/(1+Ke)3 + Div * (1+g)4/(1+Ke)4

Share Price = $1.25 * (1+17%)1/(1+6.8%)1 + $1.25 * (1+17%)2/(1+6.8%)2 + $1.25 * (1+17%)3/(1+6.8%)3 + $1.25 * (1+17%)4/(1+6.8%)4

Share Price = $1.25 * 5.05 = $6.31