The beta coefficient for Stock X is bX = 0.75. The beta coefficient for Stock Z
ID: 2700710 • Letter: T
Question
The beta coefficient for Stock X is bX = 0.75. The beta coefficient for Stock Z is bZ = -0.6. (stock Z's beta is negative, indicating that its rate of return rises whenever returns on most other stocks fall.)
A) If the risk-free rate is 8% and the expected rate of return on an average stock is 14%, what are the required rates of return on Stocks X and Z? Round your answer to 2 decimal places, XX.XX%.
B) For Stock X, suppose the current price, P0, is $42; the next expected dividend, D1, is $2.50; and the stock's expected constant growth rate is 5%. Is the stock in equilibrium? Explain, and describe what will happen if the stock is not in equilibrium. To answer this question, identify the expected rate of return (round to 2 decimal places) and what stock price will provide that return (round to the nearest cent). Enter your answer, properly formatted, in the space provided and show your work in the area below the answer box. Be sure to answer the question - is the stock in equilibrium and describe what will happen if the stock is not in equilibrium.
Explanation / Answer
A)
market rate = 14 %
for stock X
required retrun = risk free + ( market - risk free ) * beta = 8 + ( 14 - 8)*0.75 = 12.5 %
for stock Z
required retrun = risk free + ( market - risk free ) * beta = 8 - ( 14 - 8)*0.6 = 4.4 %
B)
expected rate of return = (2.5 / 42) + 5% = 0.109524 = 10.95 %
stock price that will provide this return = 42( 1 + 5% ) = 44.1
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