A stock is not expected to pay a dividend over the next four years. Five years f

Question

A stock is not expected to pay a dividend over the next four years. Five years from now, the company anticipates that it will establish a dividend of $1.00 per share (i.e., D5 = $1.00). Once the dividend is established, the market expects that the dividend will grow at a constant rate of 5 percent per year forever. The risk-free rate is 5 percent, the company's beta is 1.2, and the market risk premium is 5 percent. The required rate of return on the company's stock is expected to remain constant. What is the current stock price?

Explanation / Answer

Krf =5%, beta =1.2, Mkt Risk Prem =(Km-Krf)=5% So Ks = Krf + (Km-Krf)*beta = 5% + 5%*1.2 = 11% Horizon value of Stock at n=4 yrs is P4 =D5/(Ks-g) where g =5% & D5=1 So P4 = 1/(11%-5%) = $16.67 As there is no dividend for 4 yrs, our current stock price P0 = PV of Horizon value P4 ie P0 = P4/(1+Ks)^4 = 16.67/(1+11%)^4 = $10.98 So Current Stock price is $10.98

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