The following information is available on the following two stocks: Stock A Stoc
ID: 2671341 • Letter: T
Question
The following information is available on the following two stocks:Stock A Stock B
Beta 0.70 1.35
Risk-free Rate 5% 5%
Return on the market (Rm) 14% 14%
Most recent dividend $0.55 $1.50
Growth rate (g) 8% 9%
Price (p0) today $14.85 $23.36
If you use the security market line to determine the required rate of return and the dividend growth model
to estimate the expected return, which stock would you purchase and which would you recommend selling?
Explain.
Explanation / Answer
Security Market Line (CAPM): Required return = Risk-free rate + Beta (Return on market – Risk-free rate) Stock A ->5% + 0.70 (14% - 5%) ->5% + 6.3% -> 11.3% Stock B ->5% + 1.35 (14% - 5%) ->5% + 12.15% -> 17.15% Dividend growth Model: Expected return,r = (D1/P0) + g Stock A: D1 = $0.55 x 1.08 = $0.594; r = ($0.594/$14.85) + .08 -> 12% Stock B: D1 = $1.50 x 1.09 = $1.635; r = ($1.635/$23.36) + .09 -> 16% Recommendation: I would recommend purchasing Stock A and selling Stock B. The expected return for Stock A (12%) is more than the required return of 11.3% and hence I will recommend to purchase it. The expected return for Stock B (16%) is less than the required return of 17.15% and hence I will recommend to sell it.
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