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59533341-FM11-Ch-07-Instructors-Manual-1

# Stocks may have periods of supernormal growth where

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Unformatted text preview: initely. Stocks may have periods of supernormal growth, where gs > rs; however, this growth rate cannot be sustained indefinitely. In the long-run, g < rs. c. Assume that temp force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, and that the market risk premium is 5 percent. What is the required rate of return on the firm¶s stock? Answer: Here we use the SML to calculate temp force¶s required rate of return: rs = rRF + (rM ± rRF)bTemp Force = 7% + (12% - 7%)(1.2) = 7% + (5%)(1.2) = 7% + 6% = 13%. Mini Case: 7 - 17 d. d. Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was \$2.00, and whose dividend is expected to grow indefinitely at a 6 percent rate. 1. What is the firm¶s expected dividend stream over the next 3 years? Answer: Temp Force is a constant growth stock, and its dividend is expected to grow at a constant rate of 6 percent per year. Expressed as a time line, we have the following setup. Just enter 2 in your calculator; then keep multiplying by 1 + g = 1.06 to get D1, D2, and D3: 0 r = 13% |s g = 6% D0 = 2.00 1 2 3 4 | | | | 2.12 2.247 2.382 1.88 1.76 1.65 . . . d. 2. What is the firm¶s current stock price? Answer: We could extend the time line on out forever, find the value of Temp Force¶s dividends for every year on out into the future, and then the PV of each dividend, discounted at r = 13%. For example, the PV of D1 is \$1.76106; the PV of D2 is \$1.75973; and so forth. Note that the dividend payments increase with time, but as long as rs > g, the present values decrease with time. If we extended the graph on out forever and then summed the PVs of the dividends, we would have the value of the stock. However, since the stock is growing at a constant rate, its value can be estimated using the constant growth model: Ö0 = d. 1 rs  g = \$2.12 \$2.12 = = \$30.29. 0.13  0.06 0.07 3. What is the stock¶s expected value one year from now? Answer: After one year, D1 will have been paid, so the expected dividend stream will then be D2, D3, D4, and s...
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