You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $2.25 a share at the end of the year (D1 = $2.25) and has a beta of 0.9. The risk-free rate is 5.9%, and the market risk premium is 5.5%. Justus currently sells for $24.00 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 ?) Do not round intermediate calculations. Round your answer to the nearest cent.
Step-1, Calculation of the Required Rate of Return (Ke) using CAPM Approach
As per Capital Assets Pricing Model (CAPM), The Required Rate of Return (Ke) is calculated by using the following formula
Required Rate of Return (Ke) = Rf + [Beta x Market Risk Premium]
= 5.90% + [0.90 x 5.50%]
= 5.90% + 4.95%
= 10.85%
Step-2, Calculation of the Dividend Growth Rate (g)
Using the Dividend Discount Model (DDM), the Cost of Equity (Ke) is calculated as follows
Cost of Equity (Ke) = [D1 / P0] + g
Here, we’ve Cost of Equity (Ke) = 10.85%
Dividend in Year 1 (D1) = $2.25 per share
Current Share Price (P0) = $24.00 per share
Therefore, the Cost of Equity (Ke) = [D1 / P0] + g
0.1085 = [$2.25 / $24.00] + g
0.1085 = 0.0937 + g
g = 0.1085 – 0.0937
g = 0.0148 or
g = 1.48%
Step-3, Calculation of the Stock Price at the end of Year 3 (P3)
The Stock Price at the end of Year 3 (P3) = Current Share Price x (1 + g)3
= $24.00 x (1 + 0.0148)3
= $24.00 x (1.0148)3
= $25.08 per share
“Hence, the Stock Price at the end of Year 3 (P3) will be $25.08”
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