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P722 Integrative: Risk and valuation Given the following information for the stock of Foster Company, calculate the risk premium on its common stock.
| Current price per share of common | $50.00 |
| Expected dividend per share next year | $ 3.00 |
| Constant annual dividend growth rate | 6.5% |
| Risk-free rate of return | 4.5% |
Constant growth model also referred to as the Gordon model is used to find the value of constant growth stock.
P0 = D0(1 + g)/(rs g) = D1/(rs g)
D1 = next expected divided
Rs = the required rate of return
g the constant growth rate
P0 Current Price
Solution
Part 1
Using constant growth model, the expected rate of return
rs= D1/P0 + g
Current price, P0= $50.00
Growth rate, g = 6.5%
Expected dividend, D1= $3.00
Expected rate of return (rs) = $3/$50 + 6.5%
=6+6.5
= 12.5%
Part 2
Risk-free rate, rRF=4.5%
Expected rate of return, rs=12.5%
The equation is as follows: rs = rRF+RP
12.5% = 4.5% + RP
12.5%-4.5%= RP
Therefore, risk premium is 8%.
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