You are considering the purchase of a new stock. The stock is forecasted to pay a...

You are considering the purchase of a new stock. The stock is forecasted to pay a dividend next year (D1) of $3.49. In addition, you forecast that the firm will have a stable growth rate of 3.8% for the foreseeable future. The current risk-free rate of return is 1.4%. The expected return on the market is 11.4% and the standard deviation for the market is 13%. The stock has a correlation to the market of 0.21. Finally, the stock has a standard deviation of 24%.

Given this information, what is the value of this stock? (Hint: Use the constant growth pricing model)

Expert Solution

Beta of the stock is given as = Correlation of stock with market *(Standard deviation of stock/ Standard deviation of market)

=0.21*(24%/13%)=0.387962

Cost of equity is computed as = Risk free rate+(market return- riskfree rate)* Beta

=1.4%+(11.4%-1.4%)*0.387962

=1.4%+3.87962%

=5.276923%

Under the constant growth model=

Price = Dividend for next year/(Cost of equity - growth rate)

= 3.49/(5.276923%-3.8%)

=3.49/1.476923%

=236.3021

Hence the price of the stock should be 236.3021

jeff jeffy answered 2 years ago

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