Question

You consider buying a share of stock at a price of $10. The stock is expected to pay a dividend of $1.00 next year, and your advisory service tells you that you can expect to sell the stock in 1 year for $12. The stock's beta is 1.0, r_f is 16%, and E[r_m] = 26%. What is the stock's abnormal return?

Answer 1

Compute the expected return, using the equation as shown below:

Return = (Selling price + Dividend – Purchase price)/ Purchase price

            = ($12 + $1 - $10)/ $10

            = 30%

Hence, the expected return is 30%.

Compute the required rate of return (ROR), using the equation as shown below:

ROR = Risk free rate + {Beta*(Market rate – Risk free rate)}

         = 16% + {1*(26% – 16%)}

         = 16% + 10%

         = 26%

Hence, the ROR is 26%.

Compute the abnormal rate of return, using the equation as shown below:

Abnormal rate = Expected return – ROR

                        = 30% - 26%

                        = 4%

Hence, the abnormal rate of return is 4%.