The risk-free rate of return is 3 percent, and the expected return on the market
ID: 2679735 • Letter: T
Question
The risk-free rate of return is 3 percent, and the expected return on the market is 8.7 percent. Stock A has a beta coefficient of 1.4, an earnings and dividend growth rate of 5 percent, and a current dividend of $2.60 a share.A) What should be the market price of the stock?
B) If the current market price of the stock is $27, what should you do?
C) If the expected return on the market rises to 10 percent and the other variables remain constant, what will be the value of the stock?
D) If the risk-free return rises to 4.5 percent and the return on the market rises to 10.2 percent, what will be the value of the stock?
E) If the beta coefficient falls to 1.1 and the other variables remain constant, what will be the value of the stock?
F) Explain why the stock
Explanation / Answer
A) Required rate of return on the stock = 3 + (8.7 - 3)1.4 = 10.98% ___ MP = D(1+g) /(k-g) = 2.6(1.05)/(10.98 - 5)% = $ 45.652 ___ B) If the current market price of the stock is $27, buy as much stock as possible because the stock is undervalued according to current market price. ___ C) Required rate of return on the stock = 3 + (10 - 3)1.4 = 12.8 % ___ MP = D(1+g) /(k-g) = 2.6(1.05)/(12.8 - 5)% = $ 35 ___ D) Required rate of return on the stock = 4.5 + (10.2 - 4.5)1.4 = 12.48 % ___ MP = D(1+g) /(k-g) = 2.6(1.05)/(12.48 - 5)% = $ 36.497 ___ E) Required rate of return on the stock = 4.5 + (10.2 - 4.5)1.1 = 10.77 % ___ MP = D(1+g) /(k-g) = 2.6(1.05)/(10.77 - 5)% = $ 47.314 ___ F) due to the change in expected rate of return of the the stock.
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