Finance Question

Question

You are given the following information for ABC Inc.:

(1)  The risk free rate is 5%.

(2)  The rate of return on the market is 8%.

(3)  The expected growth rate in dividends is 4%.

(4)  The last dividend paid was $0.80 per share.

(5)  Beta is 1.0

a) What price should ABC sell for today? (8 pts)

b) What price should ABC sell for, if the growth rate in

dividends increase to 6% and beta increases to 1.5.

Answer 1

Using the CAPM formula we find the expected return on ABC:

r=5%+1(8%-5%)=8% (when beta=1 it is just the return of the market)

Now we treat the dividend as a perpetuity and price the stock as a growing perpetuity:

P=.8/(8%-4%)=$20

a) so ABC should sell for $20 today

now if the growth rate and beta increase we go back to the beginning and resolve for the return of the stock:

r=5%+1.5(8%-5%)=9.5%

P=.8/(9.5%-6%)=$22.86

b) so if the conditions are changed, ABC should sell for $22.86 today