The Joseph Company has a stock issue that pays a fixed dividend of $3.00 per share annually. Investors believe the nominal risk-free rate is 4 percent and that this stock should have a risk premium of 6 percent. What should be the value of this stock?
TO compute, use the dividend/rate of return
To compute the value of the stock, we will use the dividend discount model (DDM) formula.
The DDM formula is:
Stock Value = Dividend / (Rate of Return - Growth Rate)
In this case, the dividend is $3.00 per share annually, and the rate of return consists of the nominal risk-free rate of 4 percent plus the risk premium of 6 percent, which equals 10 percent.
Therefore, the growth rate in this case is zero, as there is no expected growth in dividends.
Substituting the values into the formula:
Stock Value = $3 / (0.10 - 0) = $30
The value of the stock should be $30.
To calculate the value of the stock, you need to use the dividend discount model (DDM) formula. The DDM formula is derived from the basic principle that the value of a stock is equal to the present value of all its future dividends.
In this case, the stock pays a fixed dividend of $3.00 per share annually, so the dividend (D) would be $3.00.
To calculate the rate of return (R), you need to add the nominal risk-free rate and the risk premium. The nominal risk-free rate is given as 4 percent, and the risk premium is given as 6 percent. Adding them together, the rate of return will be 10 percent (4% + 6%).
Now, you can use the dividend discount model formula:
Value of Stock = Dividend / Rate of Return
Substituting the values:
Value of Stock = $3.00 / 0.10
Calculating this equation, the value of the stock would be $30.00.
Therefore, the value of this stock is $30.00 based on the given assumptions.