Question

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?

Answer #1

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:

Ke=Rf+b[E(Rm)-Rf]

Where:

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)

where:

D1=next dividend payment

r=interest rate

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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