Question

Treadwater stock has a beta of 1.3. The risk-free rate of return is 3.5% and the market risk premium is 4%. Treadwater stock is a zero growth stock with a dividend of $3 per share.

a) What is the required rate of return on Treadwater stock?

b) What is the current price of Treadwater stock?

c) Suddenly, because of severe decline in the economy caused by the coronavirus and the

disruption in Treadwater’s supply chain, the beta of Treadwater increases to 1.6 and the market risk premium increases to 6% (as investors have become very risk-averse). Assuming no changes to the dividends Treadwater expects to pay on their common stock, what will be the new price of Treadwater stock?

Answer 1

Answer to a

According to CAPM or Capital Asset Pricing Model:-

Required Retrun on a Stock = Risk Free rate +(Market Risk Premium)* Beta of the stock.

Where,

RIsk Free Rate = 3.5%

Market Risk Premium = 4%

Beta of the Stock = 1.3

Now Required Rate of Return = 3.5 + 4*(1.3) = 8.7%.

Therefore the Required Rate of Return on Treadwater's Stock is 8.7%.

Answer to b

Given that the company has a zero growth rate this means that all dividends paid by the stock remains the same through out and therefore the value of Stock is determined by using the below formula

Value of Stock = Dividend / Required Rate of Return

where we have the Divided= $3 and the Required rate of return as computed above is 8.7%.

Now Value of Stock = $3 / 8.7%

Value of Stock = $ 34.483

Answer to c

We have the Beta of the Stock revised to 1.6 and the market risk premium is increased to 6%. therefore we now compute the Required rate of retrun of the stock.

According to CAPM or Capital Asset Pricing Model:-

Required Retrun on a Stock = Risk Free rate +(Market Risk Premium)* Beta of the stock.

Where,

RIsk Free Rate = 3.5%

Market Risk Premium = 6%

Beta of the Stock = 1.6

Required Rate of Return of the stock = 3.5 + 6*(1.6)

Required Rate of Return of the stock = 13.1%

Now, let us now compute the value of Stock using the same forumla as used in part b

Value of Stock = $3 / 13.1% = $22.90

Therefore the revised value of stock = $22.90.