The risk-free rate of return is 8%, the expected rate of return on the market po

Question

The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its earnings in dividends, and the latest earnings announced were $10 per share. Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 18% per year on all reinvested earnings forever.
A) What is the intrinsic value of a share of Xyrong stock?
B) If the market price of a share is currently $103, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected one-year holding-period return on Xyrong stock?

Explanation / Answer

Part A)

To determine the intrinsic value of a share of Xyrong stock, we need to calculate the required return with the use of CAPM model as follows:

Required Return = Risk Free Rate + Beta*(Expected Return - Risk Free Rate) = 8% + 1.2*(15% - 8%) = 16.4%

Now, we need to calculate the growth rate as follows:

Growth Rate = ROE*(1-Dividend Payout Ratio) = 18%*(1-40%) = 10.80%

With the use of required return and growth rate, we can calculate th intrinsic value as follows:

Intrinsic Value = Annual Dividend*(1+Growth Rate)/(Required Return - Growth Rate) = (10*40%*(1+10.80%))/(16.40% - 10.80%) = $79.14

________

Part B)

The holding period return can be calculated as follows:

Holding Period Return = [(Dividend*(1+Growth Rate) + Intrinsic Value (1+Growth Rate) - Current Market Price)]/Current Market Price*100

Using the values calculated in Part A and information provided in the question, we get,

Holding Period Return = [(4*(1+10.80%) + 79.14(1+10.80%) - 103)]/103*100 = -10.56%

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