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Excel Online Structured Activity: Constant growth You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $2
Excel Online Structured Activity: Constant growth
You are considering an investment in Justus Corporation's stock, which is expected to pay a dividend of $2.50 a share at the end of the year (D1 = $2.50) and has a beta of 0.9. The risk-free rate is 3.3%, and the market risk premium is 4.0%. Justus currently sells for $41.00 a share, and its dividend is expected to grow at some constant rate, g. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the question below.
Open spreadsheet
Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is P3?) Round your answer to two decimal places. Do not round your intermediate calculations.
Expert Solution
Computation of Stock Price at the End of 3 Years:
First we calculate Required Rate of Return using CAPM:
Required Rate of Return = Risk-free Rate + Beta*Market Risk Premium
= 3.3% + 0.9*4%
= 6.90%
According to Dividend growth rate model,
Current Stock Price = D1/(r-g)
$41 = $2.50/(6.90%-g)
$41*(6.90%-g) = $2.50
2.83-41g = $2.50
2.83-2.50 = 41g
0.33/41 = g
g = 0.80%
Now we calculate Price at the End of Year 3:
Price at the End of Year 3 = D4/(r-g)
D4 = 2.50*(1+0.80%)^3
D4 = $2.56
So,
Price at the End of Year 3 = $2.56/(6.90%-0.80%) = $41.99
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