The Zuwalt company is expected to pay a dividend of $2.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 5.00% per year in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the current market price of the stock?
Cost of Equity:
The cost of equity refers to the opportunity cost of not having invested the capital raised by issuing equity in a different project instead of a specific investment. To determine the stock value under the dividend discount model, the cost of equity is the rate that is reduced by the growth rate and is used to determine the discounted value of future dividends.
Answer and Explanation:
Zuwalt Inc's current market price of the stock is $42.21.
Zuwalt Inc.has shared the following data:
- Next dividend, D1 = $2.25
- Constant growth rate = 5%
- Beta = 1.15
- Risk premium = 5.5%
- Risk-free return = 4%
- Required return, Ke =?%
- P0 =?
The first step is to determine the Ke using CAPM:
- Ke = Risk-free return + Beta * Risk premium
- Ke = 4% + 1.15 * 5.5%
- Ke = 10.33%
The second step is to determine the P0 using the dividend discount model:
- P0 = D1 / (Ke - g)
- P0 = $2.25 / (10.33% - 5%)
- P0 = $42.21
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from Financial Accounting: Help and ReviewChapter 1 / Lesson 31