Question

2) A company that you are interested in has an ROE of 20%. Its dividend payout ratio is 60%. The last dividend, that was just paid, was $2.00 and the dividends are expected to grow at the same current rate indefinitely. Company's stock has a beta of 1.8, risk-free rate is 5%, and the market risk premium is 10%. a) Calculate the expected growth rate of dividends using the ROE and the retention ratio. b) Calculate investors' required rate of return according to CAPM. c) Based on your estimations above, how much would you be willing to pay for this stock?

Answer 1

Answer a.

Growth Rate = ROE * (1 - Payout Ratio)
Growth Rate = 20% * (1 - 0.60)
Growth Rate = 20% * 0.40
Growth Rate = 8%

Answer b.

Required Return = Risk-free Rate + Beta * Market Risk Premium
Required Return = 5.00% + 1.80 * 10.00%
Required Return = 23.00%

Answer c.

Expected Dividend = Last Dividend * (1 + Growth Rate)
Expected Dividend = $2.00 * 1.08
Expected Dividend = $2.16

Current Price = Expected Dividend / (Required Return - Growth Rate)
Current Price = $2.16 / (0.23 - 0.08)
Current Price = $2.16 / 0.15
Current Price = $14.40