Question

The risk-free rate of return is 4 percent, and the expected return on the market is 7.5 percent. Stock A has a beta coefficient of 1.6, an earnings and dividend growth rate of 8 percent, and a current dividend of $2.10 a share. Do not round intermediate calculations. Round your answers to the nearest cent.

a) What should be the market price of the stock?

b) If the current market price of the stock is $118.00, what should you do?

c) If the expected return on the market rises to 8.8 percent and the other variables remain constant, what will be the value of the stock?

d)If the risk-free return rises to 6 percent and the return on the market rises to 9.1 percent, what will be the value of the stock?

e) If the beta coefficient falls to 1.5 and the other variables remain constant, what will be the value of the stock?

Answer 1

a) required rate = risk free rate + beta *(Market return - risk free rate) =4%+1.6*(7.5%-4%) = 9.6%

Price = Dividend Next Year/( Required rate- growth) =2.10*(1+8%)/(9.6%-8%) = 141.75

b) If current price is 118 we should buy more of the stock as return will be very high.

c) New required rate = risk free rate + beta *(Market return - risk free rate) =4%+1.6*(8.8%-4%) = 11.68%

Price = Dividend Next Year/( Required rate- growth) =2.10*(1+8%)/(11.68%-8%) = 61.63

d) required rate = risk free rate + beta *(Market return - risk free rate) =6%+1.6*(9.1%-4%) = 14.16%

Price = Dividend Next Year/( Required rate- growth) =2.10*(1+8%)/(14.16%-8%) = 36.82

e)required rate = risk free rate + beta *(Market return - risk free rate) =4%+1.5*(7.5%-4%) = 9.25%

Price = Dividend Next Year/( Required rate- growth) =2.10*(1+8%)/(9.25%-8%) = 181.44

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