China America Manufacturing has a beta of 1.50, the risk-free rate of interest i

Question

China America Manufacturing has a beta of 1.50, the risk-free rate of interest is currently 6 percent, and the required return on the market portfolio is 12 percent. The company just paid a dividend of $2.50 per share and anticipates that its future dividends will increase at an annual rate of 10 percent for years one through four. Starting in year 5 the Company anticipates the dividends will grow at a rate of 8 percent and this rate will continue indefinitely into the future.

The current market price of China America Manufacturing is $38 per share. Would you recommend buying the stock at this price? Explain

Explanation / Answer

Cost of equity = risk free rate + beta *market risk premium

Cost of equity = 6% + 1.50*(12%-6%) = 15%

The price of the share should be $41.25 but it is currently trading at $38.

Hence the price of the share will increase in future and hence the stock should be bought,

Particulars 1 2 3 4 Dividends 2.75 3.025 3.3275 3.66025 Horizon value of dividends 56.4724 Total cash flow 2.75 3.03 3.33 60.13 Discounting rate 0.870 0.756 0.658 0.572 Present value 2.391 2.287 2.188 34.381 Sum of present value 41.25

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