A share of stock with a beta of .65 now sells for $46. Investors expect the stoc

Question

A share of stock with a beta of .65 now sells for $46. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 6%, and the market risk premium is 9%. a. Suppose investors believe the stock will sell for $48 at year-end. Is the stock a good or bad buy? What will investors do? The stock is a buy and the investors . b. At what price will the stock reach an “equilibrium” at which it is perceived as fairly priced today? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Stock price $

Explanation / Answer

a)

As per CAPM

Required Rate of return = Rf + market risk premium*beta

Required Rate of return = 6 + 9*0.65

Required Rate of return = 11.85%

Expected return = (Expected Dividend + Next year share price - Purchase price)/Purchase price

Expected return = (2+48-46)/46

Expected return = 8.70%

Alpha = Expected return  - Required Rate of return

Alpha = 8.70% - 11.85%

Alpha = -3.15%

Answer

The stock is a bad buy and the investors should sell the share immediately as its alpha is negative

b)

Constant Growth rate = Re - Expected Dividend/Share price

Constant Growth rate = 11.85% - 2/46

Constant Growth rate = 7.50%

Stock reach an “equilibrium” at which it is perceived as fairly priced today.

Stock price should be = 46*(1+7.5%)

Stock price should be = $ 49.45

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