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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

CONSTANT GROWTH 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 4.9%, and the market risk premium is 5%. Justus currently sells for $46.00 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.

Introduction:

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

Current stock price is $46 (given).

The constant growth rate is 4.5% or 0.045 (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 years.
  • P0 is the current stock price
  • G is growth rate.

Substitute $46 for P0 and 0.045 for g in above formula.

P3=$46(1+0.045)3=$46(1.045)3=$52.49

Working notes:

Compute the cost of equity.

Given,

The risk-free rate of return is 4.9%.

Beta is 0.9.

The market risk premium is 5%.

The formula of the required rate of return is:

Required rate of return=Risk-free rate+Beta(Market return Risk-free return)=Rf+β(RmRf)

Substitute 4.9% for Rf 0.9 for β and 5% for (RmRf) in above formula

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