Company currently pays a dividend of $1.25 per share. It is estimated that the c
ID: 2642772 • Letter: C
Question
Company currently pays a dividend of $1.25 per share. It is estimated that the company's dividend will grow at a rate of 25% per year for the next 2years, then at a constant rate of 7% thereafter. The company's stock has a beta of 1.3, the risk-free rate is 7.5%, and the market risk premium is 5%. What is the estimated stock's current price? Company currently pays a dividend of $1.25 per share. It is estimated that the company's dividend will grow at a rate of 25% per year for the next 2years, then at a constant rate of 7% thereafter. The company's stock has a beta of 1.3, the risk-free rate is 7.5%, and the market risk premium is 5%. What is the estimated stock's current price?Explanation / Answer
Using the Capital Asset Pricing Model (CAPM) and Gorden's growth model, we first find the cost of equity stock
Cost of equity = Risk free rate + (Stock Beta * Market risk premium)
= 0.075 + (1.3 * 0.05)
= 0.075 + 0.065 = 0.14 = 14%
Calculation of $ dividend = $1.25
Growth rate for first 2 year = 25% = 1.25 * (1+0.25)^2 = 1.95
Growth rate for the next year is 7%
$ Dividend at the end of 3rd year = 1.95 (1 + 0.07) = $ 2.089.
Cost of equity = (next year's annual dividend / current stock price) + dividend growth rate
0.14 = (2.089 / current stock price ) + 0.07
2.089 /current stock price = 0.14 - 0.07 = 0.07
Current stock price = 2.089 / 0.07 = $ 29.84
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