McNally Motors has yet to pay a dividend on its common stock. However, the company expects to pay a $1.00 dividend starting two years from now . Thereafter, the stock's dividend is expected to grow at a constant rate of 5 percent a year. The stock's beta is 1.4, the risk-free rate is rRF = 0.06, and the expected market return is rM = 0.12. What is the stock's expected price four years from now, i.e., what is ?
A) $10.63
B) $12.32
C) $11.87
D) $13.58
E) $11.21

Question

Quizplus · Accepted Answer

The expected price four years from now can be calculated using the Gordon Growth Model. First, calculate the required rate of return using the CAPM: r = rRF + beta * (rM - rRF) = 0.06 + 1.4 * (0.12 - 0.06) = 0.144. The dividend expected in year 4 is D4 = D2 * (1 + g)^2 = $1.00 * (1.05)^2 = $1.1025. The price at year 4 is P4 = D5 / (r - g) = D4 * (1 + g) / (r - g) = $1.1025 * 1.05 / (0.144 - 0.05) = $12.32.

McNally Motors Has Yet to Pay a Dividend on Its