Question

ABC company's ordinary shares are expected to pay $3 per share in dividends in 4 years and after which the dividends are expected to grow at 2% annually forever. Company ABC's shares have a beta of 1.75. The long-term return of ASX200 is 9% and the return of T-bonds is 4%

(a) What is the expected return of ABC's shares according to the CAPM?

(b) What is the implied price per share?

(c) If the shares are selling for $25/share, should you make the investment?

Answer 1

Given about ABC company's stock,

ABC company's ordinary shares are expected to pay $3 per share in dividends in 4 years

So, D4 = $3

and company will not pay any dividend before it.

expected growth rate thereafter g = 2%

Company's stock Beta = 1.75

return of T-bonds = Risk free rate Rf = 4%

long-term return of ASX200 = Expected return on market Rm = 9%

a). Using CAPM, expected return on a stock = Rf + Beta*(Rm - Rf)

=> expected return of ABC's shares Ke = 4 + 1.75*(9 - 4) = 12.75%

b). Share price at year 3 using constant dividend growth rate is

P3 = D4/(Ke - g) = 3/(0.1275 - 0.02) = $27.91

So, stock price today is PV of P3 discounted at Ke

=> P0 = P3/(1+Ke)^3 = 27.91/(1.1275^3) = $19.47

So, implied price per share is $19.47

c), If stock is selling for $25 per share, then it is overpriced in the current market. Since intrinsic value is less than original stock price, stock price is expected to go down. So, this investment should not be made.