WaterCo is a manufacturer of boat parts and has been in business only a few years. Its board of directors decided to start paying a dividend to help boost the attractiveness of its stock
The dividend will be $0.50 per share next year. After that dividends will increase by 4 percent per year. The company has a beta of 1.6. The market rate of return is 8% and the T-bill rate is 3%. Should you purchase shares in this firm at the current market price of $6.98 per share?
What will be an ideal response?
Answer:
Required rate of return = 3% + [1.6 (8% - 3%)]
= 3% + [1.6 (5%)]
= 11.0%
The value of a share using the constant growth dividend valuation model = $0.50/(0.11 - 0.04) = $7.14.
Yes, you should buy the stock as it is currently priced at $6.98 per share while the intrinsic value is $7.14 per share.
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