Question

A.

Beta and Value A firm is expected to pay an annual dividend of $.80 next year. After next year the firm’s dividends will grow at a steady state rate of 6% per year. You are trying to value the stock and Value Line lists a stock beta of 1.92 while Yahoo is reporting a beta of 1.89. The stock is currently priced at $15.00. If E(RM) – Rf = 4.9% and the risk free rate is 3.6% the stock is ____________________ if you use the Value Line beta and is ____________________ if you use the Yahoo beta.

overpriced by $3.34; overpriced by $3.58

underpriced by $1.50; underpriced by $1.80

underpriced by $1.80; underpriced by $1.50

overpriced by $3.58; overpriced by $3.34

B.

Deferred Dividends Downloads for Cheap, Inc. has a new business that allows customers to download music and movies directly onto their IPhones or MP3 players in grocery stores. The downloaded items can be played on their TVs or computers at home. The firm is in the high growth phase and does not currently pay dividends. Managers are estimating that the firm will begin paying an annual dividend per share of $1.40 in four years and that dividends will then grow at 5% per year thereafter. What is the most you should be willing to pay for the stock today if the required return on the stock is 14%?

$9.64

$10.50

$9.00

$11.16

Answer 1

Part A: As per CAPM we have the Expected Stock Return = risk free rate + Beta * (Market Return - risk free rate). Thus we have the Expected Stock Return = 3.6% + 1.92 * 4.9% (Value line) and 3.6% + 1.89*4.9% (Yahoo). Hence we have:

Value line ER = 13.01% and Yahoo ER = 12.86%; Now we can use the dividend discount model to arrive at the estimated price and use the above expected return as cost of equity.

As per dividend discount model, Price = Dividend/(r-g) where r is the cost of equity and g is the dividend growth rate.Price = 0.80/(13.01%-6%) = 11.42 (as per value line)

Price = 0.80/(12.86%-6%) = 11.66 (as per yahoo).

Hence we see that stock is overpriced by 3.58 as per Valueline beta and by 3.34 as per Yahoo beta

Part 2. We ill again use dividend discount model. The r = 14%, g = 5% and dividend is $1.4. Hence value of share at beginning of Year 4 (end of Year 3) should be = 1.4/(14%-5%) = 15.56. Now we will discount it to present at 14% to arrive at current value estimate = 15.56/(1+14%)³ = 10.50