Shocktown Inc. paid a dividend of $1.20 last year. The company expects to increase the dividend at a constant rate of 5% per year, indefinitely. The stock price is $10.68 currently, with a beta of 1.2. The market risk premium is 9% and the risk-free rate is 6%. What will the price of Shocktown's stock be if the market risk premium falls to 8%?

The new price will be $11.89 if the market risk premium falls to 8% changing the required rate of return to 15.6%.

Explanation:

We will calculate the price of the share today using the constant growth model of DDM as the stock's dividends are growing at a constant rate forever. The formula for constant growth model is,

P0 = D0 * (1+g) / (r - g)

Where,

We need to find the new required rate of return. The required rate is unknown and can be calculated using the CAPM. The required rate under CAPM is,

r = rRF + Beta * rpM

r = 0.06 + 1.2 * 0.08  =  0.156 or 15.6%

Plugging in the available values for new r, g and D0 to calculate price today,

P0 = 1.2 * (1 + 0.05)  /  (0.156 - 0.05)

P0 = $11.886 rounded off to $11.89

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