1. a. You expect that company A will pay its first dividend of S2 per share 3 ye
ID: 2787731 • Letter: 1
Question
1. a. You expect that company A will pay its first dividend of S2 per share 3 years from today. After that the dividend is expected to grow at an annual rate of 5% for ever. The risk free rate is 690, and the expected rate of return on the market is 10%. Also, the covariance between stock A and the market is 0.10, and standard deviation of the market portfolio is 20%. What is the fair value of the stock today? b. Assume that the actual price is less than what you have calculated in part a. What does this say about its actual return compared to what is predicted by the security market line? c. If it is true that properly priced securities fall on the security market line, what would you expect to happen to the price of stock A given that it is currently less than your calculation from part a? Explain why you believe that a price change would occur.Explanation / Answer
Beta=Covariance(stock,market)/variance of market
Beta of A=0.10/0.2^2=2.5
Return on equity=risk free + beta*(market return-risk free)=6%+2.5*(10%-6%)=16%
Price=D1/(r-g)=D3/((1+r)^2*(r-g))=2/(1.16^2*(16%-5%))=13.512
If actual price is less than the fair value or intrinisc value, it means it is undervalued hence, it appears above SML. Or its actual return is more than what is predicted by SML
Price of stock A would increase so as to fall on SML because otherwise arbitrage is possible through posiitons in risk free asset and market portfolio
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