JAD just paid a dividend of $0.80. Analysts expect dividends to grow at 25% in the next two years, 15% in years three and four, and 8% for year five and after. The market required rate of return is 10%, and Treasury bills are yielding 4%. JAD has a beta of 1.4. The estimated current price of JAD is closest to: A) $45.91. B) $29.34. C) $25.42. JAD’s stock price today can be calculated using the three-stage model. Start by finding the value of the dividends for the next four years with the two different dividend growth rates. D1 = D0(1+g) = $0.80(1.25) = $1.00 D2 = D1(1+g) = $1.00(1.25) = $1.25 D3 = D2(1+g) = $1.25(1.15) = $1.4375 D4 = D3(1+g) = $1.4375(1.15) = $1.6531 Believe it or not, my computer won’t show me the rest of the answer. I thought… 1. V4 = D5 / r-g, which equals: 1.6531(1.08) / .10 - .08 = 90.92…which is nowhere near the answer. 2. Any help out there? Regards,
You are not using the current discount rate here. 10% is Rm and not the required return on Jad. You can calculate the required return by using CAPM: 4% + 1.4 *(10-4)=12.4% Use this as the discount rate to calculate the present value and you will get the correct answer.
V4=D5/(r-g) r = 4 + 1.4(10-4) = 12.4% V4 = 1.653125 * 1.08/(.124-.08) = 40.58 Now V0 using Cash flow function: 29.35 choice B You used the return on market instead of using Beta and calculating return on equity…
thanks, I had the wrong required rate of return. I got confused by the wording: " The market required rate of return is 10%" and I used that # instead of computing r via CAPM.
market reqd rate of return is nothing by E(Rm)… sometimes they might throw in Market Risk premium as well… then make sure you do not deduct rf again from that number…
yup, I fell for the old “market required rate of return” trick…instead of investor’s required rate of return or required rate of return on the stock… (I hope that’s right)