Question

Compton Corp. is expected to pay a $2.50 dividend to its common stockholders one year from today. You expect these dividends to grow at a constant annual rate of 5% indefinitely. The risk-free rate is 3% and the market risk premium is 7%. If Compton Corp.has a beta of 1.50, what is the expected percentage increase in the price of its common stock one year from today?

Select one: a. 3% b. 7% c. 5% d. none of the above

Answer 1

Calculate the required rate of return as follows:

Required return = Risk free rate + (Beta *risk premium)

= 3% + (1.5%*7%)

=3% + 10.50%

= 13.50%

Therefore, the required rate is 13.50%.

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Calculate the current price of the stock as follows:

Current price of the stock = Expected dividend /(Required rate - Growth rate)

= $2.5/(13.50% - 5%)

=$29.4118

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Calculate the year one price of the stock as follows:

Current price of the stock = Expected dividend in year 2 /(Required rate - Growth rate)

= ($2.5)*(1+5%))/(13.50% - 5%)

=$30.8824

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Calculate the change in price as follows:

Change in price = (Closing price - Opening price)/Opening price

= (30.8824 - $29.4118)/$29.4118

= 5%

Therefore, the change in price is 5%.