financial investment

Question

The annual risk-free rate of return is 2 percent and the investors believes that the market will rise annually at 7 percent. If a stock has a beta coefficient of 1.5 and its current dividend is $1, what should be the value of the stock if its earnings and dividends are growing annually at 4 percent?

Answer 1

1 Find the required rate of return on the stock

 

Using the Capital Asset Pricing Model, the required rate of return on the stock is:

 

Required rate of return on stock = Risk-free rate of return +(Beta*(Market rate of return - risk-free rate of return))

 

Required rate of return on stock = .02 +(1.5*(.07 - .02))

Required rate of return on stock = .02 +(1.5*.05)

Required rate of return on stock = .02 +.075

Required rate of return on stock = .095, or 9.5 percent

 

2. Find the stock price

 

Using the Gordon Dividend Growth Model, we find that:

 

Current stock price = (Current Dividend*(1+growth rate))/(Required rate of return - growth rate)

Current stock price = ($1*(1+.04))/(.095 - .04)

Current stock price = ($1*1.04)/.055

Current stock price = $1.04/.055

Current stock price = $18.91