Gamma Corporation and Delta Inc. are both part of the S&P 500. The S&P 500 is fo
ID: 2625203 • Letter: G
Question
Gamma Corporation and Delta Inc. are both part of the S&P 500. The S&P 500 is forecasted to increase by 10% over the next year. The current yield on 90 day Treasuries is 2%.
Information about Gamma and Delta are set forth below (EPS Growth is the forecast over the next year).
Beta EPS DPS EPS Growth
Gamma 1.5 $4 $1 12%
Delta 0.8 $5 $4 4%
A) Using the CAPM, what is the required return for Gamma and Delta?
B) Using the dividend growth model, the required returns calculated in (a) above, and assuming no change in payout ratios, what should the current stock price for Gamma and Delta be?
Explanation / Answer
A) Using the CAPM, what is the required return for Gamma and Delta?
Required return for Gamma = Risk free rate + (Return on Market -Risk free rate)*beta
Required return for Gamma = 2 + (10-2)*1.5
Required return for Gamma = 14%
Required return for Delta = Risk free rate + (Return on Market -Risk free rate)*beta
Required return for Delta = 2 + (10-2)*0.8
Required return for Delta = 8.4%
B) Using the dividend growth model, the required returns calculated in (a) above, and assuming no change in payout ratios, what should the current stock price for Gamma and Delta be?
EPS over the next year:
Gamma = 4*1.12 = 4.48
Delta = 5*1.04 = 5.20
DPS over the next year i.e D1 of each company
Gamma = 4.48 *1/4 = 1.12
Delta = 5.20*4/5 = 4.16
Current Stock Price:
Gamma = 1.12/(0.14-0.12) = $ 56
Delta = 4.16/(0.084-0.04) = $ 94.55
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