Temple Lunch Trucks, Inc. just paid a dividend of $2.00. Dividends are expected to grow at a rate of 3% per year from here on out. If the risk-free rate is 2%, the MRP is 8%, and Temple Lunch Trucks’ stock is only 40% as risky as the market, what is the most that you should be willing to pay for a share of this stock today?
Risk free rate= 2%
Market risk premium= 8%
Since the company is only 40% as risky as the market, the beta is 0.4.
The formula for calculating the required rate of return on the stock is given below:
Rf=risk-free rate of return
Rm=expected rate of return on the market.
Rm-Rf= Market risk premium
b= Stock’s beta
Ke= 2% + 0.4*8%
= 2% + 3.20% = 5.20%.
Next, the price of the stock is calculated using the dividend discount model.
Price of the stock today=D1/(r-g)
D1=next dividend payment
g=firm’s expected growth rate
Price of the stock today= $2*(1+0.03)/ 0.052- 0.03
= $2.06/ 0.0220 = $93.64.
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