You are considering two stocks. Both pay a dividend of $1, but the beta coeffici

Question

You are considering two stocks. Both pay a dividend of $1, but the beta coefficient of A is 1.5 while the beta coefficient of B is 0.7. Your required return is

k = 8% + (15% - 8%)

a) What is the required return for each stock?

b) If A is selling for $10 a share, is it a good buy if you expect earnings and dividends to grow at 5 percent?

c) The earnings and dividends of B are expected to grow annually at 10 percent. Would you buy the stock for $30?

d) If the earning and dividends of A were expected to grow annually at 10 percent, would it be a good buy at $30?

PLEASE SHOW ALL WORK - THANK YOU!

Explanation / Answer

Answer to Part A:

K = 8% + (15% - 8%) Beta

Required rate of Return for Stock a = 8% + (15% - 8% ) 1.5

Required rate of Return for Stock a = 18.5%

Required rate of Return for Stock b = 8% + (15% - 8% ) 0.7

Required rate of Return for Stock b= 12.9%

Answer to Part b:

Current price = $ 10

K = 18.5%

G = 5% = 0.05

As per Dividend Model : P = D0 (1+g) / (k-g)

P = 1 (1 + 0.05) / (0.185 – 0.05)

P = $ 7.78

Therefore, if the Current price of the stock is $ 10, then it is overpriced and should not be bought.

Answer to Part c:

Current price = $ 30

K = 12.9 % = 0.129

G = 10% = 0.10

As per Dividend Model : P = D0 (1+g) / (k-g)

P = 1 (1 + 0.10) / (0.129 – 0.10)

P = $ 37.93

Therefore, if the stock is available at $ 30, we should buy it

Answer to Part d:

P = D0 (1 +g )/ (k-g)

P = 1 (1+0.10) / (0.185- 0.10)

P = (1 * 1.10) / 0.085              

P = 12.94

As the Current price is lower, we should not buy it

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