An investment portfolio includes stock A and B. The relevant figure are: Assume

Question

An investment portfolio includes stock A and B. The relevant figure are: Assume that the risk free rate of interest is 2% and that the market return is 12%. Required Calculate the portfolio expected return and the portfolio beta. (6%) According to the Capital Asset Pricing Model (CAPM), which stock(s) will bring benefits to investor? Why? Calculate the reward-to-risk ratio of stock A. Assume firm A just paid dividend of $ 1.5 and the dividend growth rate is 5%. What is the intrinsic value of the common stock? If the current price of stock A is $22. Would you buy more or sell stock A? Why?

Explanation / Answer

a) Portfolio return = (WA*BetaA) + (WB*BetaB)
=> (0.4*0.12) + (0.6*0.15) = 0.138 or 13.8%

Portfolio Beta = (WA*BetaA) + (WB*BetaB)
=> (0.4*1.1) + (0.6*1.3) = 1.22

b) According to Capital Asset Pricing Model, stock B will bring more benefits to investors as it has higher expected returns.

c) Risk/reward = (Expected Ret - Rf) / Beta.
=> (0.12 – 0.02)/1.1 = 0.0909 or 9.09%

d) Intrinsic Value = Dividend*(1+G) / (Ke-G)
=> ($1.5*1.05) / (0.12 – 0.05) = $22.50

e) If the current price is $22, you should buy more as the intrinsic value is $22.50 and stock prices will move up to meet its intrinsic value.

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