Lynn N. Chute and G. Robert Sledd (Bob) are analysts for Wutz-Next Investments Inc., WNI. They both forecast that Pete-Sake Corp. will pay a $3.36 annual dividend in one year. Analysts in the capital markets group at WNI estimate a risk-free rate of 3%, market risk premium of 6.5%, and a beta of 1.0 for Pete-Sake common stock.

a. Bob forecasts that dividends will grow indefinitely at a constant rate of 5.5% per year beyond year 1. Lynn estimates that dividends will grow at a constant rate of 6.0%. Compute the value for Pete-Sake stock using Bobs estimate and then using Lynns. In general, are estimates obtained from the constant growth stock valuation formula very sensitive to dividend growth rate estimates?

b. Assume that Bob now agrees with Lynns 6.0% growth estimate. However, they believe that new CPI data that will be released in the next few days will confirm their suspicion of higher inflation in the near future. They argue that both short-term and long-term Treasury rates will quickly increase by about a full percentage point, and therefore the appropriate risk-free rate is 4%, not 3%. Compute the new value for Pete-Sake common stock. Compare the result to Lynns result in part a. What is the expected effect of higher inflation on common stock prices?

c. CPI data released later that week showed that their fears of increased inflation in the near term were correct and that the 4% risk-free rate was appropriate. One of the more senior analysts at WNI now suggests that the 6.5% market risk premium is too low and suggests raising it by half a percentage point. Compute the value of Pete- Sake stock using a market risk premium of 7%. Describe the relationship between the market risk premium and stock prices. What events in the U.S. in the last 30 years or so might have at least briefly affected the market risk premium?