Question

Bonnie and Clyde the Houston’s company's pension fund management division, with Bonnie having responsibility for fixed income securities (primarily bonds) and Clyde being responsible for equity investments. A major new client, Ms. Victoria, has requested that Houston Company present an analysis of Sugar Land Company (SLC) she is considering to purchase.

Assume that Sugar Land (SLC) has a beta coefficient of 1.2, that the risk-free rate (the yield on 10-year Treasury-Note) is 7 percent, and that the market risk premium is 5 percent, (Survey of all analysts).

1. According to CAPM, what is the required rate of return on SLC’s stock?
2. Assume that Sugar Land is a constant growth company whose last dividend D0, was $2.0, and whose dividend is expected to grow indefinitely at a 6 percent rate.

Answer the followings:                                                                                   

a. What is the firm’s expected dividend stream over the next 3 years?             
b. What is the firm’s current stock price?
c. What is the stock's expected value 1 year from now?            
d. What is the expected dividend yield, the capital gains yield, and the total return during the first year?       
  
3. Now assume that the stock is currently selling at $30.29. No, other changes.

a. What is the expected rate of return on the stock?
b. What would the stock price be if its dividends were expected to have zero growth? (Zero growth model, K is the same but g=0)

Answer 1

1. The required rate of return on SLC stock using CAPM model :-

= Rf + beta * (Rm-Rf)

= 7 + 1.2 * (12-7) (where Rm = Rf + risk premium)

=13%

2 (a) Firm expected dividend stream over 3 years as follows

Y1= 2*1.06 = $ 2.12

Y2 = 2*(1.06)^2 = $ 2.25

Y3 = 2*(1.06)^3 = $ 2.39

2(b) Firm current stock price using dividend growth model

= D1/(r-g)

(where D1 refers to dividend at the end of year 1 = 2*(1.06) = 2.12 ; r = required rate of return ; g = growth rate)

= 2.12 / (0.13 - 0.06)

= $ 30.29

2 (c) Stock expected value 1 year from now

P1 = D2/ (r-g)

(where P1 refers to price of stock at end of Year 1 and D2 refers to expected dividend for year 2)

= 2.25 / (0.13-0.06)

= $ 32.14

2(d) Dividend yield = D1/ P0

= 2.12/ 30.29 = 7%

Capital gain yield = (P1-P0)/P0

= (32.14-30.29)/30.39 = 6.11%

Total return yield = Dividend yield + Capital gain yield

= 7 + 6.11 = 13.11%

3 (a) Expected rate of return derived from dividend growth model

= (D1/P0)+g

= (2.12/30.29) + 0.06 = 13%

3(b) P0 = D/r

= 2/0.13 = $ 15.38