Question

Step 1:

Risk Free Rate = Rf = 4%

Return on Market = Rm = 12.75%

Beta = β = 1.6

Required rate of Return using CAPM formula = Rf + β (Rm - Rf)

= 4% + 1.6 (12.75% - 4%)

= 4% + 14%

= 18%

Required Rate of Return is 18%

Step 2:

Last Dividend = D0 = \$1.5

Dividend in Year 1 = D1 = D0 * (1+g) = \$1.5 * (1+20%) = \$1.8

Dividend in Year 2 = D2 = D1 * (1+g) = \$1.8 * (1+20%) = \$2.16

Dividend in Year 3 = D3 = D2 * (1+g) = \$2.16 * (1+20%) = \$2.592

Dividend in Year 4 = D4 = D3 * (1+g) = \$2.592 * (1+20%) = \$3.1104

Dividend in Year 5 = D5 = D4 * (1+g) = \$3.1104 * (1+0) = \$3.1104

Value of Dividend at year 4 for years 5 to forever =H = D5 / Required rate of return = \$3.1104 /18% = \$17.28

Step 3:

Current Common Stock Price = Present value of all dividends

= [D1 / (1+r)^1] + [D2 / (1+r)^2] + [D3 / (1+r)^3] + [D4 / (1+r)^4] + [H / (1+r)^4]\

= [\$1.8 / (1+18%)^1] + [\$2.16 / (1+18%)^2] + [\$2.592 / (1+18%)^3] +[\$3.1104 / (1+18%)^1] + [\$17.28 / (1+18%)^4]

= [\$1.8 / 1.18] + [\$2.16 / 1.3924] + [\$2.592 / 1.643032] + [\$3.1104 / 1.93877776] + [\$17.28 / 1.93877776]

= \$1.52542373 + \$1.55127837 + \$1.57757122 + \$1.60430972 + \$8.91283176

= \$15.1714148

Therefore, Current Common Stock Price is \$15.17

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