Question

Shocktown Inc. paid a dividend of $1.20 last year. The company expects to increase the dividend at a constant rate of 5% per year, indefinitely. The stock price is $10.68 currently, with a beta of 1.2. The market risk premium is 9% and the risk-free rate is 6%. What will the price of Shocktown's stock be if the market risk premium falls to 8%?

Answer 1

The new price will be $11.89 if the market risk premium falls to 8% changing the required rate of return to 15.6%.

Step-by-step explanation:

We will calculate the price of the share today using the constant growth model of DDM as the stock's dividends are growing at a constant rate forever. The formula for constant growth model is,

P0 = D0 * (1+g) / (r - g)

Where,

• D0 * (1+g) is the dividend expected for the next period or D1
• r is the required rate of return
• g is the growth rate in dividends

We need to find the new required rate of return. The required rate is unknown and can be calculated using the CAPM. The required rate under CAPM is,

r = rRF + Beta * rpM

r = 0.06 + 1.2 * 0.08 = 0.156 or 15.6%

Plugging in the available values for new r, g and D0 to calculate price today,

P0 = 1.2 * (1 + 0.05) / (0.156 - 0.05)

P0 = $11.886 rounded off to $11.89