Central Development Company just paid a dividend of $3.00 per share. The company
ID: 2803021 • Letter: C
Question
Central Development Company just paid a dividend of $3.00 per share. The company just entered a very profitable growth mode and expects that its dividend will grow 15% annually over the next three years. In the spirit of under promising and over delivering, Central Development has told investors that after the third year it expects the annual dividend to grow at a more reasonable rate of 2% per year. Currently, the risk free rate (RRF) is 2.5%, the market risk premium (RPM) is 6.5%, and Central’s beta is 1.5. (4 points) a. If you want to buy Central’s stock today, how much are you willing to pay? b. If you buy Central’s stock today, how much will you be able to sell it for at the end of year 4? (i.e., what is the stock’s price at the end of year 4?)
Explanation / Answer
a) CAPM = rf + beta*market risk premium
= 0.025+ (1.5*0.065)
= 12.25%
Dividends paid for next four years:
Present value of cash flows at end of 3 years = 4.65 / (0.1225-0.02)
= $45.36
Price of stock in the current period is calculated as below:
Therefore, to buy Central's stock today, one would pay $41.52 today.
b) Stock price at the end of year 4.
Expected dividend in year 4 = 4.65*1.02 = 4.74
Price of stock at end of year 4 = 4.74 / (0.1225-0.02)
= $46.27
Period growth rate dividend 0 3.00 1 15% 3.45 2 15% 3.97 3 15% 4.56 4 2% 4.65Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.