Question

Human’s Inc.’s last dividend (D0) was $1.25, and its earnings and dividends are expected to increase at a constant growth rate of 5%. Humana’s market beta is 1.2. If the current risk-free rate is 3% and the required rate of return on the market portfolio is 12%, what is the company’s current expected stock price? Choice: $7.50 Choice: $9.58 Choice: $14.92 Choice: $17.89

Answer 1

Information provided:

Last dividend= $1.25

Growth rate= 5%

Beta= 1.2

Risk free rate= 3%

Required return on the market portfolio= 12%

The question is solved by caclualting the cost of equity which is computed using the capital asset pricing model.

The formula for calculating the capital asset pricing model is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

B= Beta of the company

Ke= 3% + 1.2*(12% - 3%)

     = 3% + 10.80%

     = 13.80%

The current stock price is calculated using the dividend discount model.

Price of the stock today=D1/(r-g)

where:

D1=next dividend payment

r=interest rate

g=firm’s expected growth rate

Price of the stock today= $1.25*(1 + 0.05)/ 0.1380 – 0.05

                                             = $1.3125/ 0.0880

                                             = $14.9148

Hence, the answer is option c.

In case of any query, kindly comment on the solution.