Question

The security market line is estimated to be

k=5% + (9.7% - 5%)β.

You are considering two stocks. The beta of A is 1.3. The firm offers a dividend yield during the year of 5 percent and a growth rate of 8.6 percent. The beta of B is 1.6. The firm offers a dividend yield during the year of 5.9 percent and a growth rate of 8 percent.

Stock A:   %

Stock B:   %

The difference in the required rates of return is the result of -Select-stock Astock BItem 3 being riskier.

Stock A -Select-shouldshould notItem 4 be purchased.

Stock B -Select-shouldshould notItem 5 be purchased.

-Select-Stock AStock BNeither of stocksBoth stocksItem 6 should be purchased.

1. What is the required return for each security? Round your answers to two decimal places.
2. Why are the required rates of return different?
3. Since A offers higher potential growth, should it be purchased?
4. Since B offers higher dividend yield, should it be purchased?
5. Which stock(s) should be purchased?

Answer 1

a. Required Return of Stock A =5% + (9.7% - 5%)β =5%+(9.7%-5%)*1.3 =11.11%
Required Return of Stock B =5% + (9.7% - 5%)β =5%+(9.7%-5%)*1.6=12.52%

b. The required Rates of Return because beta of B is higher and hence Stock B is more riskier.

c. The Expected Return of Stock A =Dividend Yield + capital Gain =5%+8.6% =13.6%
Stock A should be purchased because Expected Return is greater than required Rate of return.

d. The Expected Return of Stock B =Dividend Yield + capital Gain =5.9%+8% =13.9%
Stock B should be purchased because Expected Return is greater than required Rate of return.

e. Both Stock should be purchased