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In: Finance

You find a stock priced at $27.35 with a beta of 1.5. The stock pays a...

You find a stock priced at $27.35 with a beta of 1.5. The stock pays a dividend of $1.20 and is expected to be priced at $28.50 next year. If the risk-free rate is 2% and the market risk premium is 6%, would you buy the stock?

Solutions

Expert Solution

Step-1:Calculation of required rate of return
As per Capital Asset Pricing Model,
Required rate return = Risk Free return + Beta*Market risk premium
= 2.00% + 1.5*6%
= 2.00% + 9.00%
= 11.00%
Step-2:Calculation of price of bond
Price of bond = (D1+P1)/(1+Ke)
= (1.20+28.50)/(1+0.11)
= $    26.76
Where,
D1 Dividend at the end of year 1 = $       1.20
P1 Price at the end of year 1 = $    28.50
Ke Required rate of return = 11.00%
As per dividend discount model, price of stock is the present value of dividend.
Since current price of stock is $ 27.35 which is more than $ 26.76, I would not buy the price at this price
as it is an overpriced stock.

jeff jeffy answered 1 year ago
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