You are considering an investment in the common stock of Keller Corp\'s stock, w

Question

You are considering an investment in the common stock of Keller Corp's stock, which is expected to pay a dividend of $2 a share at the end of the year (D1 = $2.00). The stock has a beta equal to 0.9. The risk-free rate is 5.6%, and the market risk premium is 6%. The stock's dividend is expected to grow at some constant rate g. The stock currently sells for $25 a share.

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 P1?)

Explanation / Answer

E(R) = R(f) + R(m)- R(f)* beta

E(R) = 5.6% + 6%

E(R) = 11.6%

P0 = Div1/r-g

$25 = $2/.116 - g

g=.036 or 3.6%

P1 = P0(1+ g)

P1 = $25(1+.036) = $25.9

P2 = $25.9(1+.036) = $26.83

P3 = $26.83(1+.036) = $27.80

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