Question

Xila-Fone Corp. expects to earn $4.00 per share next year, with an expected payout of 30%. Investors expect the dividend to grow at a constant rate of 8% for the foreseeable future. The risk-free rate is 5%, and the beta that is 10% more volatile than the market as a whole, and the expected return on the market is 14%. What is the estimated price of the stock

Answer 1

P0 = $17.39130 rounded off to $17.39

Step-by-step explanation:

The constant growth model of dividend discount model (DDM) can be used to calculate the price of the stock today. DDM calculates the price of a stock based on the present value of the expected future dividends from the stock. The formula for price today under constant growth DDM is,

P0 = D1 / (r - g)

Where,

• D1 is the dividend expected in Year 1 or next year
• g is the constant growth rate in dividends
• r is the discount rate or required rate of return

However, to calculate the Price of the stock today, we must first calculate the required rate of return (r) for the stock. The required rate of return can be calculated using the CAPM equation. The equation is as follows,

r = rRF + Beta * (rM - rRF)

Where,

• rRF is the risk free rate

• rM is the expected return on market

We know the risk free rate and expected return on market and we also know that the beta of market is always equal to 1. So, the beta of stock which is 10% more volatile than the market will be,

Beta of stock = 1 * 10% + 1 = 1.1

r = 0.05 + 1.1 * (0.14 - 0.05)

r = 0.149 or 14.9%

The dividend expected for next year will be,

D1 = 4 * 30% = $1.2 per share

Using the DDM,

P0 = 1.2 / (0.149 - 0.08)

P0 = $17.39130 rounded off to $17.39