Sure Tool Company is expected to pay a dividend of $2 in the upcoming year and t

Question

Sure Tool Company is expected to pay a dividend of $2 in the upcoming year and to grow at a constant rate of 4%. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. The beta of Sure Tool Company's stock is 1.25.

(A) What is the investor’s required rate of return on Sure's stock?

(B) What is the intrinsic value of Sure's stock today?

(C) If Sure’s stock is traded at $13.5 today, is Sure’s stock market price under- or over-valued? Would you recommend to buy or short sell Sure’s stock?

Explanation / Answer

Required rate of return = Risk free rate + Beta ( Market return - Risk free return )

= 4% + 1.25(14%-4%)

= 4% + 12.5% i.e 16%

Intrinsic value = D1/Ke-G

= 2/(16%-4%)

= 16.67

Sure market price is undervalued and it should be bought today

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