Question

In: Finance

The risk-free rate of return is 2 percent, and the expected return on the market is...

The risk-free rate of return is 2 percent, and the expected return on the market is 7.1 percent. Stock A has a beta coefficient of 1.6, an earnings and dividend growth rate of 5 percent, and a current dividend of $3.20 a share. Do not round intermediate calculations. Round your answers to the nearest cent.

$  

The stock -Select-shouldshould not be purchased.

$  

$  

$  

The increase in the return on the market -Select-increasesdecreases the required return and -Select-increasesdecreases the value of the stock.

The increase in the risk-free rate and the simultaneous increase in the return on the market cause the value of the stock to -Select-increasedecrease .

The decrease in the beta coefficient causes the firm to become -Select-lessmore risky as measured by beta, which -Select-increasesdecreases the value of the stock.

  1. What should be the market price of the stock?
  2. If the current market price of the stock is $49.00, what should you do?
  3. If the expected return on the market rises to 12.2 percent and the other variables remain constant, what will be the value of the stock?
  4. If the risk-free return rises to 5 percent and the return on the market rises to 12.9 percent, what will be the value of the stock?
  5. If the beta coefficient falls to 1.5 and the other variables remain constant, what will be the value of the stock?
  6. Explain why the stock’s value changes in c through e.

Solutions

Expert Solution

1. Required Rate of return = Risk Free + Beta * (Market Return - Risk Free) = 2% + 1.6 * 5.1% = 10.16%

What should be the market price of the stock?

Market Price = Dividend * (1 + Growth rate) / (Cost of Capital - Growth Rate)

Market Price = $3.20 * (1 + 0.05) / (10.16% - 5%)

Market Price = $65.12

If the current market price of the stock is $49.00, what should you do?

The stock should be purchased as market price is less than intrinsic value of share.

If the expected return on the market rises to 12.2 percent and the other variables remain constant, what will be the value of the stock?

New Required Rate of return = Risk Free + Beta * (Market Return - Risk Free) = 2% + 1.6 * 10.2% = 18.32%

New Market Price = Dividend * (1 + Growth rate) / (Cost of Capital - Growth Rate)

Market Price = 3.20 * (1 + 0.05) / (18.32% - 5%)

New Market Price = $25.23

The increase in the return on the market increases the required return and decreases the value of the stock.

If the risk-free return rises to 5 percent and the return on the market rises to 12.9 percent, what will be the value of the stock?

New Required Rate of return = Risk Free + Beta * (Market Return - Risk Free) = 5% + 1.6 * 7.9% = 17.64%

New Market Price = Dividend * (1 + Growth rate) / (Cost of Capital - Growth Rate)

Market Price = 3.20 * (1 + 0.05) / (17.64% - 5%)

New Market Price = $26.58

The increase in the risk-free rate and the simultaneous increase in the return on the market cause the value of the stock to -increase.

If the beta coefficient falls to 1.5 and the other variables remain constant, what will be the value of the stock?

Required Rate of return = Risk Free + Beta * (Market Return - Risk Free) = 2% + 1.50 * 5.1% = 9.65%

New Market Price = Dividend * (1 + Growth rate) / (Cost of Capital - Growth Rate)

Market Price = 3.20 * (1 + 0.05) / (9.65% - 5%)

New Market Price = $72.26

The decrease in the beta coefficient causes the firm to become less risky as measured by beta, increases the value of the stock.

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