Question

A company is expected to pay a dividend of $1.34 per share one year from now and $1.96 in two years. You estimate the risk-free rate to be 4.4% per year and the expected market risk premium to be 5.1% per year. After year 2, you expect the dividend to grow thereafter at a constant rate of 5% per year. The beta of the stock is 1, and the current price to earnings ratio of the stock is 16. What would be an appropriate estimate of the stock price today? (Answer to the nearest penny, i.e. 55.55 but do not use a $ sign).

Answer 1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 4.4 + 1 * (5.1)

Expected return% = 9.5

	Required rate=	9.50%
Year	Previous year dividend	Dividend growth rate	Dividend current year	Horizon value	Total Value	Discount factor	Discounted value
1	0	0.00%	1.34		1.34	1.095	1.2237
2	1.34	0.00%	1.96	45.733	47.693	1.199025	39.77649
	Long term growth rate (given)=	5.00%			Value of Stock =	Sum of discounted value =	41
Where
Total value = Dividend + horizon value (only for last year)
Horizon value = Dividend Current year 2 *(1+long term growth rate)/( Required rate-long term growth rate)
Discount factor=(1+ Required rate)^corresponding period
Discounted value=total value/discount factor