Question #57809

A financial analyst has been following Biostar 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 Biostar Inc beta is 1.75. The current earnings per share (EPS0) isRM2.50.
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?

Expert's answer

Use the SML equation to solve for rs.

rs = 0.0625 + (0.05)*(1.75) = 0.15 = 15%.

Calculate dividend per share, D0:

(EPS0)*(Payout ratio) = D0

($2.50)*(0.4) = $1.00.

Calculate the dividend and price stream (once the stock becomes a constant growth stock):

D0 = $1.00; D1 = $1.00*1.25 = $1.25; D2 = $1.25*1.20 = $1.50; D3 = $1.50*1.15 = $1.725; D4 = $1.725*1.07 = $1.8458.

Use the cash flow register to calculate PV, and then solve for NPV = $18.53.

rs = 0.0625 + (0.05)*(1.75) = 0.15 = 15%.

Calculate dividend per share, D0:

(EPS0)*(Payout ratio) = D0

($2.50)*(0.4) = $1.00.

Calculate the dividend and price stream (once the stock becomes a constant growth stock):

D0 = $1.00; D1 = $1.00*1.25 = $1.25; D2 = $1.25*1.20 = $1.50; D3 = $1.50*1.15 = $1.725; D4 = $1.725*1.07 = $1.8458.

Use the cash flow register to calculate PV, and then solve for NPV = $18.53.

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