Assume that the current risk free rate of return is 1.5% and the required rate o

Question

Assume that the current risk free rate of return is 1.5% and the required rate of return on the market as a whole has averaged historically 7%. Using the CAPM, what is the appropriate required rate of return for Alton Industries, a firm with a beta of 1.25?

Using the required rate of return you calculated for Alton, given a PROJECTED dividend of $1.65 (d1), and a growth rate of 3%,calculate the price their stock should be selling for using the Gordon Growth pricing model we studied in the previous unit of material.

Explanation / Answer

Required return (CAPM) = Rf+×Rp

Rf is risk free return

is beta of the security

Rp is risk premium

= 1.50%+1.25×(7%-1.50%)

= 8.375%

Stock price, P0 = D1÷(r-g)

D1 is next expected dividend

r is required return

g is growth rate

= $1.65/(8.375%-3%)

= $30.70

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