This is the Next Annual Dividend divided by the Expected Market Return minus the Annual Growth Rate of Dividends. However, the value of common stock is the Next Annual Dividend divided by the Investors' Required Rate of Return minus the Annual Growth Rate of Dividends.
This answer does not take into account the growth rate in the dividend.
To determine the value of the common stock, it is necessary to use both the Capital Asset Pricing Model, to find the current cost of Martin's common equity (investors' required rate of return), and then the Dividend Growth Model, to find the price of the common stock. The Capital Asset Pricing Model formula is: R = R F + [β(RM ? R F)]. Plugging the values into the formula, we have .07 + [1.25(.15 ? .07)] which equals .17 or 17%, which is the investors' required rate of return. We now have all the information needed to use the Dividend Growth Model to value this stock. The formula for the Dividend Growth Model is restated to solve for the stock price, as follows: P0 = Next Annual Dividend / (Investors' Required Rate of Return ? Annual Growth Rate of Dividends) P0 = ($1.00 × 1.05) / (.17 ? .05) = $1.05 ÷ .12 = $8.75
This is the previous year's dividend divided by the expected market return. However, the value of common stock is found by means of the Constant Growth Model, which is Next Annual Dividend divided by the Investors' Required Rate of Return minus the Annual Growth Rate of Dividends.
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Additional Data: The long term debt was originally issued at par ($1,000 per bond) and is currently trading at $1,250 per bond. Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds. The current risk-free rate (U.S. Treasury bonds) is 7%. The expected market return is currently 15%. The beta for Martin is 1.25. Martin's effective corporate income tax rate is 40%. Martin paid a dividend of $1.00 per share last year.. Martin's dividend is expected to grow at the rate of 5% per year. What price should Martin's common stock sell for currently?