EHB Truck Company is selling stock for 13$. The stock just paid a dividend of $.
ID: 2805247 • Letter: E
Question
EHB Truck Company is selling stock for 13$. The stock just paid a dividend of $.60 and this dividend is expected to grow by 15% per year for three years. After that it will grow at a constant rate of 4%. The stocks beta is 1.7, the risk-free rate of interest is 2.5% and the market risk premium is 5.25%. Should you buy the stock? (Round to dollars and cents or two decimal points) EHB Truck Company is selling stock for 13$. The stock just paid a dividend of $.60 and this dividend is expected to grow by 15% per year for three years. After that it will grow at a constant rate of 4%. The stocks beta is 1.7, the risk-free rate of interest is 2.5% and the market risk premium is 5.25%. Should you buy the stock? (Round to dollars and cents or two decimal points)Explanation / Answer
Dividend at the end of third year = 0.6*(1 + 15/100)^3 = 0.6 * 1.52 = $0.91
Now this dividend of $0.91 is expected to grow at the constant rate of 4% every year from end of third year onwards.
Value of the stock at the end of 3rd year = ?
Discount Rate using CAPM: Rf + B(Rm) where Rm is Market Risk Premium & Rf is Risk Free Rate
Discount Rate = 2.5% + 1.7 * (5.25%) = 2.5% + 8.925% = 11.4%
Value of stock at the end of 3rd year = Do (1 + g) / (r - g) = $0.91 (1 + 0.04) / (0.114 - 0.04) = 0.9464 / 0.074 = $12.79
Cashflow of stock
D1 = Dividend at the end of first year = 0.6*1.15 = 0.69
D2 = Dividend at the end of second year = 0.69*1.15 = 0.79
D3 = Dividend at the end of third year = 0.79*1.15 = 0.91
P3 = Price at the end of thrd year = $12.79
Total cash flow at the end of third year = D3 + P3 = 0.91 + 12.79 = $13.70
Total Discounted cash flows for the stock = D1 / (1 + r) + D2 / (1 + r)^2 + (D3 + P3) / (1 + r)^3
r = 11.4%
Discounted Cash Flow Equation = (0.69 / 1.114) + (0.79 / 1.114^2) + (13.70 / 1.114^3)
0.62 + 0.64 + 9.913 = $11.17
Since the current market price of stock i.e. $13 is more than intrinsic value calculated i.e. $11.17, so it is overvalued and we should not buy the stock.
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