Question

You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $2.25 a share at the end of the year (D₁ = $2.25) and has a beta of 0.9. The risk-free rate is 5.0%, and the market risk premium is 4.5%. Justus currently sells for $38.00 a share, and its dividend is expected to grow at some constant rate, g. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the question below. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is ?) Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

Stock price at the end of year 3 (P3)= D4/(Re+g)

Where D4= dividend for the year 4, Re= required rate of return on equity and g= constant growth rate of dividend.

As per CAPM, Required rate of return= Rf+ Beta*Rp

Where Rf= Risk free rate (given as 5%, Beta given as 0.9 and Rp= Market Risk premium (given as 4.5%)

Therefore, Re= 5% + 0.9*4.5% = 9.05%

Given, D1= $2.25. Current price (P0)= $38

Constant Dividend Growth rate (g)= Re-(D1/P0) = 0.0905-(2.25/38)= 0.03128947

D4= D1*(1+g)^3 = $2.25*1.03128947^3 = $2.467881333

Stock price at the end of year 3 (P3)= D4/(Re+g)= $2.467881333/(0.0905-0.03128947)= $41.68