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7 January, 18:57

Memories of the 2007-2009 financial crisis have made you more risk averse, doubling the risk premium you require to purchase a stock. Suppose that your risk premium before the crisis was 4 percent and that you had been willing to pay $412 for a stock with a dividend payment of $10 and expected dividend growth of 3 percent.

Using the dividend discount model, with unchanged risk-free rate, dividend payment and expected dividend growth, what price would you now be willing to pay for this stock?

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  1. 7 January, 21:28
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    Price=D (1+g) / r-g

    Dividend = $10

    g=3%

    risk premium=4%

    Price=$412

    Solution:

    In order to find the r=cost of equity we undertake the following steps

    Price=D (1+g) / r-g

    412=10 (1+0.03) / r-0.03

    r-0.03=10.3/412

    r-0.03=0.025

    r=0.025+0.03

    r=0.055 or 5.5%

    risk premium = (market risk - risk free rate)

    0.04 = (0.055 - risk free rate)

    risk free rate = 0.015 or 1.5%

    as we double the risk premium rate from 4% to 8%

    then

    market risk will be

    risk premium = market risk - risk free rate (unchanged)

    8%=market risk - 1.5%

    market risk = 9.5%

    Using dividend discount model

    Price=D (1+g) / r-g

    price = 10 (1+0.03) / 0.095-0.03

    Price = $158
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