Use the dividend growth model in order to determine the growth rate of a company with the following data:
Current stock price: $50.00
Expected end of period dividend $ 3.75
Equity beta: 0.75
Market risk premium 8%
Risk free rate 5%
What is the weighted average cost of capital of this company if the debt/equity ratio is 0.25 and the debt is considered to be risk-free?
What is the expected end of period price? Hence, what is the expected capital gain?
Suppose an analyst agrees with all the data given above, but expects an end of period price for this stock of $53. Show that this stock does not lie on the security market line. If the market as a whole would adopt the view of this analyst, then how does the stock price have to move so that expected returns are consistent with the CAPM again?
Suppose that at the end of the period the company pays a dividend of only $2.50. How does the stock price react when the dividend announcement is made and the market had no prior knowledge of the dividend cut? Assume that on the dividend announcement day the market expects that the reduced dividend reflects a temporary problem, so that dividends will bounce back to $3.75 one year after the cut and resume growing at the original rate after that.
How does your answer change if the dividend cut reflects a permanent reduction in earnings prospects, so that the dividends resume growth at the rate you computed above immediately after the dividend payment of $2.50?