Estimate the intrinsic value of Carma Corp. using the dividend discount model under each of the following separate assumptions:

a. The dividend is expected to last into perpetuity.

b. The dividend will be $0.95 next year and then will grow at a rate of 5% per year.

c. The dividend will be $0.85 for the next four years and then will grow at a rate of 5%.

8. Carma Corp. currently pays a dividend of $0.85 per share. In addition, Carma's market beta is 2.2 when the risk free rate is 5% and the expected market premium is 7%. Estimate the intrinsic value of Carma Corp. using the dividend discount model under each of the following separate assumptions:

a. The dividend is expected to last into perpetuity.

b. The dividend will be $0.95 next year and then will grow at a rate of 5% per year.

c. The dividend will be $0.85 for the next four years and then will grow at a rate of 5%.

Explanation:

a) The steps to solving this question involves

1. The dividend discount model which is given by the formula: P = d / (r-g) where P = price of a share, d = dividend, r = rate of return, g = growth rate.

2. Rate of return is not given in the question and can be derived using the Capital Asset Pricing Model (CAPM). Expected Return = Rf + b (Rm - Rf) where rf = risk free rate, rm = market rate and b = beta

Therefore r = 5+2.2 (7-5) = 9.4%

3. Substituting 9.4% for r in the dividend discount model: P = 0.85 / (0.094-0) = $9.04

b) Value of Carma with 1 year holding period is given by the dividend discount formula: (D1 (1+g) / (1+r)) + P1 / (1+r)

where P1 = price of a share in 1 years time, d = dividend in 1 years time, r = rate of return, g = growth rate.

Therefore P1 = Price of share in 1 year time which is determined by a summation of Price of the share now (P0 solved in 'a' above without any holding period) and the current year dividend (D0). Which is $9.4 + 0.85 = $10.25.

P0 with 1 year holding period = (0.95 (1+0.05) / (1+.094)) + (10.25 / (1+.094) = $10.28

c) Where the dividend remains constant over a horizon of 4 years the price every year is determined by the addition of the constant dividend. Hence in years 1-4, P1 = 9.04 + P2 = (9.04+0.85) + P3 = (9.04+0.85+0.85) + P4 = (9.04+0.85+0.85+0.85) + P5 ahead at a growth of 5% = (0.85 (1+0.05) / (1+.094) = $42.08