Question

Check My Work eBook Problem Walk-Through You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $1.50 a share at the end of the year (D = $1.50) and has a beta of 0.9. The risk-free rate is 5.4%, and the market risk premium is 5.5%. Justus currently sells for $49.00 a share, and its dividend is expected to grow at some constant rate, g. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is P?) Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Beta of Justus Corporation Stock (Be) = 0.9

Risk Free rate (Rf) = 5.4%

Market Risk Premium (Rm-Rf) = 5.5%

Justus current price (P0) = $49 per share

Expected Dividend (D1) = $1.50 per share

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Therefore, as per CAPM ,

Required rate of Return (Re) = Rf + (Rm-Rf)*BE

Re = 5.4% + 5.5%*0.9

Re = 10.35%

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Let growth rate be “g”

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As per Gordon Model,

P0 = D1/(Re-g)

49 = 1.50/(0.1035-g)

0.1035 – g = 1.50/49

0.1035 – g = 0.030612

g = 0.1035-0.030612

g = 0.072888

g = 7.2888%

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Price of the share at the end of three years (P3) = Current Price of the share*(1+growth rate)^three years

P3 = P0*(1 + 0.072888)^3

P3 = 49*(1.072888^3)

P3 = 49*1.234988

P3 = $60.51443

P3 = $60.51…(rounded off to two decimal places)