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Example 1: Thames Inc.s most recent dividend was $2:40 per share
(i.e. D0 = $2:40). The dividend is expected to grow at a constant rate
of 6% per year. The risk-free rate is 5% and the return on the market is
9%. If the companys beta is 1:3, what is the price of the stock today?
Answer: First, lets nd the required rate of return rs :
rs = rRF + s (rM
) rs = 10:2%
rRF ) = 5% + 1:3(9%
P0 =
5%)
D1
) rs =
rs g
) rs = 13%
D1
$2:40
+ g ) rs =
+ 5%
P0
$30
P0current =
new
s
= rRF + new
rRF )
s (rM
new
) rs = 4% + 2(4%) = 12%
2
P0 = $81:54 =
P0old = $100 =
After the increase in beta we know that the price dropped to P0new =
$80; which implies that
P0new
2(1 + 0:1078)
rsnew 0:1078
2(1 + 0:1078)
0:1078 =
80
= 13:55%
= $80 =
) rsnew
) rsnew
= 13:55% = 4% +
= 1:91
) new
s
new
s (5%)
D0 (1 + g spinof f )
rsspinof f
g spinof f
>
D0 (1 + g current )
= P0current
rscurrent g current
g spinof f
(1)
We know that
g spinof f = 6% and g current = 8%
f
rsspinof f = 4% + spinof
(4%)
s
current
rscurrent = 4% + s
(4%) = 4% + 1:6(4%) = 10:4%
Therefore, the condition in (1) becomes
(1 + 6%) (10:4%
spinof f
(4%)
s
OR
(1:06) (0:024)
1:08
spinof f
s
> 0:04 +
spinof f
(0:04)
s
0:06
spinof f
(0:04)
s
6%