Question

PLEASE SHOW WORK

Stock A is selling for $40 per share, has an expected growth rate of 8 percent, is expected to pay a dividend of $4 per share next year, and its beta is estimated to be 2.00.The risk-free rate of interest is 4 percent and the market risk premium is 5 percent.

A.If the expected inflation rate is expected to return to 1 percent, but the market risk premium increases to 7 percent, what is the risk-free rate of interest?

What is the expected return on the market?4%; 11%

B. If the expected inflation rate is expected to remain at 1 percent and the market risk premium is 7 percent, is Stock A over, under, or correctly valued at a market price of $40?correctly valued

C. If the expected inflation rate is expected to remain at 1 percent and the market risk premium is 7 percent, what is Stock A’s equilibrium price?$40

Answer 1

Part A)

The value of risk-free rate of interest and expected return on the market is arrived as follows:

Risk-Free Rate of Interest = Nominal Risk-Free Rate of Interest = 4% (given in the question)

Expected Return on the Market = Risk-Free Rate of Interest + Market Risk Premium = 4% + 7% = 11%

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Part B)

We will have to calculate the stock price with the use of information given in the question to determine whether it is over, under, or correctly valued with the use of formula given below:

Current Stock Price = Dividend Next Year/(Required Return - Growth Rate)

Here, Dividend Next Year = $4, Required Return = Risk Free Rate + Beta*Market Risk Premium = 4% + 2*7% = 18% and Growth Rate = 8%

Substituting values in the above formula, we get,

Current Stock Price = 4/(18% - 8%) = $40

As the stock price of $40 arrived above is same as the price at which the stock is currently selling (as given in the question), we can conclude that the stock is correctly valued.

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Part C)

The stock's equilibrium price can be calculated with the use of same formula as provided in Part B). Therefore, the equilibrium price would be $40 only.