Earnings Inc. just paid a dividend of $4.05 per share. It should grow at a rate of 17% for each of the next two years, then 10% the year after and settle down to a growth rate of 5% per year thereafter. Its beta is 1.2, the market risk premium is 7.6% and T-bills trade at 2%.
How much is the dividend at time 1 (D1)?
How much is the dividend at time 2 (D2)?
How much is the dividend at time 3 (D3)?
What rate of return do investors require on this Earnings Inc. stock? [Enter the value in decimal format. For example, if your answer is 12.34%, enter as 0.1234]
What is the time-3 present value of all cash flows from time 4 on into the future?
At what price should Earnings Inc. stock sell today?
Answer(1): Dividend = $4.05, g1 = 17%, g2 = 17%, g3 = 10%
Next dividend = Current dividend (1+Growth rate)
Dividend at time 1 (D1) : 4.05 (1+.17) = $4.7385
Dividend at time 2 (D2) : 4.7385 (1+.17) = $5.544
Dividend at time 3 (D3): 5.544 (1+.10) = $6.0984
(2): Calculating of Required rate of return: From CAPM:
Re = Rf + Beta (Rpm)
Where; Re = Required rate of return, Rpm = Market risk premium, Rf = Risk free return.
Given: Re = ?, Rm = 7.6%, Rf = 2%, Beta = 1.2
Putting all the above values in the formula, we get:
Re = .02 + 1.2 (.076)
Re = .1112
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