Question

A company’s stock has the following attributes:

• Current Market price of $37.50
• Current annual dividend of $2.50
• Constant dividend growth rate of 5%
• A beta of 1.00

The risk-free rate is currently 5% and the market risk premium is 7.0%. If the risk-free rate suddenly jumps to 6.25% what happens to this company’s stock price (Give the price to 2 decimal places)?

Answer 1

Current Market Price = $37.5

Current annual Dividend = $2.50

Constant dividend growth rate(g) = 5%

Beta = 1.00

risk free rate = 5%

Market risk premium = 7%

Required return (under CAPM) = Rf + Beta*market risk premium

thus, Current required return = 5% + 1*7%

= 12%

Now, If risk free rate suddenly jumps to 6.25%

then ,

New required return = 6.25% + 1*7%

= 13.25%

As Discount Dividend Model, Stock price(P) can be calculated in following manner -

where,

D = Current dividend

g = Constant growth rate

k = Required return

putting the values -

Thus, If risk rate jumps to 6.25% then Stock price reduced by $5.68 to $ 31.82

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.