Question

Q3: Ram’s stock is currently selling for $160.00 per share and the firm's dividends are expected to grow at 5 percent indefinitely. In addition, Ram’s stock most recent dividend was $5.50. The expected risk free rate of return is 3 percent, the expected market return is 8 percent, and Ram’s stock has a beta of 1.20.

Required:

1. Estimate the expected return based on the dividend valuation model.
2. Estimate the required rate of return using CAPM and Draw the security market line (SML).
3. Would Ram’s stock be a good investment at this time? Explain.  
4. State clearly any limitations and assumptions that you made in your calculations.

Answer 1

a) Expected return based on dividend valuation model = (Next year's dividend/Current stock Price) + Dividend growth rate

Expected return based on the dividend valuation model = (5.5*1.05/160) + 0.05 = 0.08609

Expected return based on the dividend valuation model = 8.61%

b)

According to CAPM model,

Required rate of return = Risk-free return+ Beta*(Market return-Risk-free return)

Required rate of return = 0.03 + 1.2*(0.08-0.03) = 0.09

Required rate of return = 9.00%

Beta	Expected return
0.1	3.50%
0.2	4.00%
0.3	4.50%
0.4	5.00%
0.5	5.50%
0.6	6.00%
0.7	6.50%
0.8	7.00%
0.9	7.50%
1	8.00%
1.1	8.50%
1.2	9.00%
1.3	9.50%
1.4	10.00%
1.5	10.50%
1.6	11.00%
1.7	11.50%
1.8	12.00%

c) The expected return (part a) is lesser than the required rate of return using CAPM model. Hence, Ram’s stock would not be a good investment at this time.

d) In the dividend discount model, we assume that dividends are paid forever and the dividend growth rate remains 5%.

Also, we assume that the current stock price reflects the intrinsic value of the stock.