Mr. Hillbrandt is impressed with your ability to explain financial concepts so h

Question

Mr. Hillbrandt is impressed with your ability to explain financial concepts so he asks for help with learning about stock valuation. Mr. Hillbrandt really liked the examples you provided last time (module 1), so it seems as if you need to sit down and create some relevant examples for this topic too. Below is some information that helps you brush up on the topic. Read this article related to the intrinsic value of stock, paying special attention to the section entitled “Constant Growth Model”: Alvarez, S. (2015). What is the intrinsic value of stock? Investopedia. Retrieved from http://www.investopedia.com/articles/basics/12/intrinsic-value.asp Now, let’s work the following problem: A company just paid an annual dividend of $2.00 per share. Dividends are anticipated to grow at a rate of 8% per year forever. The stock’s beta is 1.5, the risk-free rate is 2.5%, and the expected return on the overall stock market is 7.5%. What’s the intrinsic value of the company’s common stock? Using the formula: Stock Price = D1 ÷ (k – g) Where: D1 = dividend for the coming year k = required rate of return (NOTE: k must be greater than g) g = growth rate of dividends (Note: Decimals and not percentages must be used for the model to work) 1) To calculate the dividend for the coming year, we need to multiply the last dividend by the expected dividend growth rate. And so: D1 = $2.00 x 1.08 = $2.16 2) Find the Market risk premium using the following formula: Market risk premium = Expected return on stock - Risk free rate = 7.5% - 2.5% = 5% 3) Then, to find k, or the required rate of return, use the following formula: k = risk free rate + [market risk premium x beta] = 2.5% + (5% * 1.5) = 10% 4) g = 8% (or 0.08) growth rate of dividends 5) Stock Price = D1 ÷ (k – g) = $2.16 ÷ (.10 - .08) = $2.16 ÷ .02 = $108.00 (ANSWER) 5) Check your answer with this online calculator: http://www.zenwealth.com/businessfinanceonline/SV/CGStockCalculator.html Now, work the following problems: A company just paid an annual dividend of $3.25 per share. Dividends are anticipated to grow at a rate of 5% per year forever. The stock’s beta is 1.2, the risk-free rate is 3.5%, and the expected return on the overall stock market is 5.5%. What’s the intrinsic value of the company’s common stock? ANSWER = $379.17 A company just paid an annual dividend of $2.35 per share. Dividends are anticipated to grow at a rate of 6.25% per year forever. The stock’s beta is 1.6, the risk-free rate is 4.25%, and the expected return on the overall stock market is 8.5%. What’s the intrinsic value of the company’s common stock? ANSWER = $51.48

Explanation / Answer

Answer:D1= $3.25 x 1.05 = $3.4125

Ke=Rf+beta(Erm-Rf)

=3.5%+1.2(5.5%-3.5%)

=5.9%

Stock Price = D1 ÷ (k – g)

= $3.4125 ÷ (.059 - .05) = $379.17

Answer:

D1= $2.35 x 1.0625 = $2.4969

Ke=Rf+beta(Erm-Rf)

=4.25%+1.6(8.5%-4.25%)

=11.05%

Stock Price = D1 ÷ (k – g)

= $2.496875 ÷ (.1105 - .0625)

= $52.02

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