Acompany is about to go public. it announces that it plans to pay a $1 per share dividend in its first year of existence and 2$ in its second year. from year 3 onwards dividends are expected to grow at a constant rate of 10% per year. the risk free rate is 5%, the company's beta is 2 and the expected market return is 20%. what should be the ipo stock price?

Issue price of IPO = $5.41442

Explanation:

As provided:

Using capital asset pricing model we have:

Expected return on security = Rf + Beta (Rm - Rf)

Where Rf = Risk free rate of return

Rm = Market return

Expected return = 5% + 2 (20% - 5%)

= 0.05 + 0.30

= 35%

Year 3 dividend = $2 + 10% = $2.20

Thus price using dividend growth model

=

Its discounted value = $8.80 0.4064 = $3.57632

Year 2 dividend = $2, its discounted value @ 35% = $2 0.5487

= $1.0974

Discounted value of dividend of year 1 = $0.7407

Total price of stock = $0.7407 + $1.0974 + $3.57632 = $5.41442

the correct answer is:

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