6. The risk-free rate of return is 3 percent, and the expected return on the mar
ID: 2660570 • Letter: 6
Question
6. The risk-free rate of return is 3 percent, and the expected return on the market is 8.7 percent. Stock A has a beta coefficient of 1.4, an earnings and dividend growth rate of 5 percent, and a current dividend of $2.60 a share.
a. What should be the market price of the stock?
b. If the current market price of the stock is $27, what should you do?
c. If the expected return on the market rises to 10 percent and the other variables remain constant, what will be the value of the stock?
d. If the risk-free return rises to 4.5 percent and the return on the market rises to 10.2 percent, what will be the value of the stock?
e. If the beta coefficient falls to 1.1 and the other variables remain constant, what will be the value of the stock?
f. Explain why the stocks value changes in c through e?
Explanation / Answer
Current Dividend = 2.6
Dividend after 1 year = D1 = 1.05*2.6 = $2.73
Expected Rate of Return = Risk free rate + beta* Risk Premium = 3 + 1.4*(8.7-3) = 10.98%
a)
P = D1/(r-g) = 2.73/(0.1098 - 0.05)
P = $ 45.65
b)
I would buy the stocks ...becuase it is undervalued.
c)
Expected Rate of Return = Risk free rate + beta* Risk Premium = 3 + 1.4*(10-3) = 12.8%
P = D1/(r-g) = 2.73/(0.128 - 0.05)
P = $ 35
d)
Expected Rate of Return = Risk free rate + beta* Risk Premium = 4.5 + 1.4*(10.2-4.5) = 12.48%
P = D1/(r-g) = 2.73/(0.1248 - 0.05)
P = $ 36.5
e)
Expected Rate of Return = Risk free rate + beta* Risk Premium = 3 + 1.1*(8.7-3) = 9.27%
P = D1/(r-g) = 2.73/(0.0927 - 0.05)
P = $ 54.6
f)
As Expected Market rate rises...Expected rate of return also rises hence the stock price will go down as we have more expectations now ......
Similarly when Risk free rturn rises ...risk is reduced ...so Stock price will go up somewhat
When beta is reduced to 1.1 it means our expected rate comes near to market rate so...our stock moves as market moves ....
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