A company currently pays a dividend of $1.8 per share (D0 = $1.8). It is estimated that the company's dividend will grow at a rate of 18% per year for the next 2 years, and then at a constant rate of 6% thereafter. The company's stock has a beta of 1.2, the risk-free rate is 8.5%, and the market risk premium is 4%. What is your estimate of the stock's current price? Do not round intermediate calculations. Round your answer to the nearest cent.
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:
Ke=Rf+b[E(Rm)-Rf]
where:
Rf= risk-free rate of return
Rm= expected rate of return on the market.
b= stock’s beta
Ke= 8.5% + 1.2*4%
= 8.5% + 4.80%
= 13.30%
D1= $1.8*(1 + 0.18)
= $2.1240
D2= $1.8*(1 + 0.18)^2
= $2.5063
D3= $2.5063*(1 + 0.06)
= $2.6567
Present value of dividend= $2.1240/ (1 + 0.1330) + $2.5063/ (1 + 0.1330)^2
= $2.1240/ 1.1330 + $2.5063/ 1.2837
= $1.8747 + 1.9524
= $3.8271
Price at year 2= $2.6567/ (0.1330 - 0.06)
= $2.6567/ 0.0730
= $36.3932
Present value= $36.3932/ (1 + 0.1330)^2
= $36.3932/ 1.2837
= $28.3502
Stock price= $3.8271 + $28.3502
= $32.1773 $32.18.
In case of any query, kindly comment on the solution.
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