Question

Suppose that a firm just paid an annual dividend of $1.20 per share. This grows at 10% per year for each of the next two years, after which it will grow at 3% per year forever. The market risk premium is 7%. The firm has a tax rate of 25%, cost of debt is 6%, market value based D/E is 0.5, ROE is 12%, beta is 1.5, Rf is 4%. Using the dividend discount model,

a) What discount rate will you use?

b) What is the logic for your answer to (a) above?

c) Use the dividend discount model to value the stock today.

Answer 1

a)

As per CAPM,

Rf = Risk free Return = 4%

Rmp = Market Risk Premium = 7%

Beta for Stock = 1.5

Required Return = 4% + 1.5(7%)

Required Return of Stock= 14.5%

So, the discount will be 14.5%

b). Since, we have to compute the Stock value, we will take Required rate of return as per CAPM as discounted rate because to compute to value of stock we will always ake the cost of equity Required rate of return on equity as discount rate.

c)

Dividend paid (D0) = $1.20

Growth rate for first 2 years (g) = 3%

Growth rate thereafter (g1) = 3%

Required Return of Stock(ke)= 14.5%

calculating the value of stock today using dividend discount model:-

Price = 1.1528 + 1.1075 + 9.9196

Price = $ 12.18

value of Stock Today is $ 12.18