The common stock of Escapist Films selss for $25 a share and offers the followin

Question

The common stock of Escapist Films selss for $25 a share and offers the following payoffs next year: Boom dividend = 5$ Stock price= $195, Normal economy dividend= $2 Stock price =$100 and Recession dividend = 0 and stock price= 0. The company goes out of business if a recession hits. Calculate the expected rate of return and standard deviation of return to Leaning Tower of Pita shareholders. Assume for simplicity that the three possible states of the economy are equally likely. The stock is selling today for $80

Explanation / Answer

Return in each of the scenario = (Change in stock price + Dividend) / Initial stock price

Boom Return = (195 - 80 + 5 ) / 80 = 150%

Normal return = (100 - 80 + 2) / 80 = 27.5%

Recession return = ( 0 - 80 + 0) / 80 = -100%

Assuming equal probability of the three states, expected return = (150 + 27.5 + -100)/3 = 25.8%
Standard deviation of return = Square root (((150 - 25.8)^2 + (27.5 - 25.8)^2 + (-100 - 25.8)^2) / (3-1)) = 125%

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