A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast Start's beta is 1.75. The current earnings per share (EPS0) is $2.50. The company has a 40 percent payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent this year, 20 percent next year, and 15 percent the following year. After three years the dividend is expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its current payout ratio. The analyst believes that the stock is fairly priced. What is the current price of the stock?

Question

Quizplus · Accepted Answer

The current price of the stock can be calculated using the Dividend Discount Model (DDM) with varying growth rates. First, calculate the required rate of return using the Capital Asset Pricing Model (CAPM): Required return = Risk-free rate + Beta * Market risk premium = 6.25% + 1.75 * 5% = 14%. Next, calculate the dividends for the first three years using the growth rates and payout ratio. Then, calculate the terminal value at the end of year 3 using the constant growth rate of 7%. Finally, discount all future dividends and the terminal value back to the present value using the required rate of return. The calculations result in a current stock price of approximately $18.53.

A Financial Analyst Has Been Following Fast Start Inc