Question

5. The company’s common stock is going to pay a dividend is $2.00 per share after one year. Dividends are expected to grow at 10 percent per year for 2 years after that ($2.20 two years from now, and $2.42 3 years from now), and 4% thereafter.

The expected market return is 6%, your stock has a beta of 1.2. The return on riskless government bonds is 2%.

1. Assuming CAPM is correct, what should be the price of the stock?

2. Suppose the market price of the stock is $30 (different from the price that CAPM says it should be), what would you tell the investors about investing in the stock?

Concept Check: Capital is acquired in the marketplace. For many of us it is in the form of loans; publicly traded companies have access to debt in the form of bonds and equity in the form of stocks. In any instance we are being judged as to how much of a risk is the capital at for not being recovered. Risks include (but are not limited to); inflation or the erosion of the value of my money; opportunity costs in the form of interest free government securities, compensation for the chance of not being paid back (default risk), compensation for the length of time the capital is at risk (maturity) and compensation for the ability to be able to turn the investment of capital into cash by trading it or converting the obligation (liquidity risk).

Helpful Hint: We need to look at this from the market perspective of what is a fair rate of return for the investment compared to alternatives available.

Answer 1

1)
Cost of equity = Rf + Beta x (Rm - Rf)
Cost of equity = 2% + 1.2 x (6% - 2%)	6.80%
Year	Dividend	PV @ 6.80%	Present Value
1	$2.00	0.9363	$1.87
2	$2.20	0.8767	$1.93
3	$92.31	0.8209	$75.77
Intrinsic Value			$79.57
Horizon Value = $2.42 x (1+ 4%)/(6.80% - 4%)	$89.89
Year 3 Cash flow = ($2.42 + 89.89)	$92.31
2)
The market price is less than the intrinsic value its good opportunity for investors to invest in this stock as the market is undervaluing the stock.