Question

Question 5 Revisions:

Casinooi just paid a dividend of $1 per share. The dividend is expected to grow at a constant rate of 10% per year forever. The stock has a beta of 1.25 and the risk- free rate is 7%, while the expected rate of return of the whole market is 12%.

a) What is the required rate of return on the Casinooi stock

b)  What is your estimate of the intrinsic value of a share of the Casinooi stock?

c)  Currently the market price of the stock is $33. Is the Casinooi stock fairly priced? Briefly explain your answer.

d)  If you expect a market price per share of $36 one year from now, what is the expected rate of return on this stock? Based on your calculation from a) and d) find out if the Casinooi stock is underpriced or overpriced?

Answer 1

Solution:-

(a)

As per CAPM equation, the required rate of return is calculated as follows:

Required rate of return (Cost of equity)= Risk free rate + beta*(Expected return of market - risk free rate) = 7% + 1.25*(12%-7%) = 13.25%

(b)

Based on dividend discount model, the intrinsic value is as follows:

Intrinsic value= Expected dividend 1 year from now/(Cost of equity-perpetual growth rate)= ($1*110%)/(13.25%-10%) = $33.85

(c)

If the intrinsic value of stock is $33.85 and the stock is currently priced at $33, it means that the stock is undervalued marginally at present. This is because the investors can current buy stock at a price lower than its intrinsic value. However, it is very close to its fair value. So, we can say it is marginally undervalued.

(d)

Expected return from stock = (Expected price after one year - current price)/Current price = ($36-$33)/$33 = 9.1%

Now, the required rate of return as calculated in part (a) is 13.25% whereas the expected return from stock is just 9.1%. This means that the stock is not expected to perform as well as it should or in other words the stock is currently overpriced which is why its expected return is lesser than the required rate of return.