Question

eBook Problem 11-08 Two stocks each currently pay a dividend of $1.90 per share. It is anticipated that both firms’ dividends will grow annually at the rate of 3 percent. Firm A has a beta coefficient of 1.1 while the beta coefficient of firm B is 0.87. Stock A: $   Stock B: $   The beta coefficient of -Select-stock Astock BItem 3 is higher, which indicates the stock's return is -Select-lessmoreItem 4 volatile. Stock A is -Select-undervaluedovervaluedItem 5 and -Select-shouldshould notItem 6 be purchased. Stock B is -Select-undervaluedovervaluedItem 7 and -Select-shouldshould notItem 8 be purchased. If U.S. Treasury bills currently yield 3.9 percent and you expect the market to increase at an annual rate of 8.2 percent, what are the valuations of these two stocks using the dividend-growth model? Do not round intermediate calculations. Round your answers to two decimal places. Why are your valuations different? If stock A’s price were $43 and stock B’s price were $57, what would you do?

Answer 1

Expected return of Stock A = Risk Free + Beta * (Market Rate - Risk Free Rate)

Expected return of Stock A = 3.90% + 1.1 * (8.20%-3.90%)

Expected return of Stock A = 3.90% + 1.1 * 4.30%

Expected return of Stock A = 8.63%

Expected return of Stock B = Risk Free + Beta * (Market Rate - Risk Free Rate)

Expected return of Stock B = 3.90% + 0.87 * (8.20%-3.90%)

Expected return of Stock B = 3.90% + 0.87 * 4.30%

Expected return of Stock B = 7.641%

a. Stock price of A = Dividend * (1 + Growth) / (Expected return - Growth) = 1.90 * 1.03 / (8.63%-3%) = $34.76

Stock price of B = Dividend * (1 + Growth) / (Expected return - Growth) = 1.90 * 1.03 / (7.641%-3%) = $42.17

b. The beta coefficient of stock A is higher, which indicates the stock's return is more volatile.

c. If stock A’s price were $43 and stock B’s price were $57, what would you do?

Stock A is overvalued and should not be purchased.

Stock B is overvalued and should not be purchased.