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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

CONSTANT GROWTH You are considering an investment in Keller Corporation’s stock, which is expected to pay a dividend of 52.00 a share at the end of the year (D1 = $2.00) and has a beta of 0.9. The risk-free rate is 5.6%, and the market risk premium is 6%. Keller currently sells for $25.00 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 ^ 3 ?)

Summary Introduction

To determine: The stock price at the end of 3 years.

Cost of Equity

It is the cost of the company while raising finance by issuing equity. It is earnings from the investment to the firm’s equity investors. It is the return to the stockholder holders’ equity investments. The issue of new stock incurs the flotation cost.

Explanation

Given,

Current stock price is $25

Constant growth rate is 3% (working note).

The formula to calculate the price of the stock at the end of 3 years is:

P3=P0(1+g)3

Where,

  • P3 is stock price after 3 year
  • P0 is current stock price
  • G is growth rate.

Substitute $25 for P0 and 0.030 for g in above formula.

P3=$25(1+0.03)3=$25×1.092727=$27.31

Thus stock price is $27.31.

Working notes:

Compute cost of equity.

Given,

Risk-free rate of return is 5.6%.

Beta is 0.9

Market risk premium is 6%.

The formula of cost of equity is:

Cost of Equity=Risk-free Rate+Beta(Market return Risk-free return)=Rf+β(RmRf)

Substitute 5.6% for Rf0.9 for β and 6% for (RmRf) in above formula

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