Question

Consider the following for Snuggli Corporation.

• Snuggli’s price is $50

• Snuggli just paid an annual dividend of $3

• Snuggli’s projected growth rate for the foreseeable future is 8%

• Snuggli’s beta is 1.1.

• Risk-free rate is 3%

• Expected return for the market is 10% Calculate the following

a) Calculate Snuggli’s required rate of return, using CAPM.

b) Calculate Snuggli’s value, using CAPM and the Gordon constant growth model.

c) Compare Snuggli’s price to rice to Snuggli’s value from b) above.

d) Compare Snuggli’s Gordon return to Snuggli’s CAPM required rate of return from a) above

Answer 1

a) Rate of return (CAPM) = Rf + beta*(Rm - Rf)

= 0.03 + 1.1*(0.10-0.03)

= 10.70%

b) Share Price (As per gordon growth model) = D1/(Ke - g)

D1 = Dividend at year 1 (D0 *(1+g))

Ke= expected return

P = 3(1 + 0.08)/(0.1070 -0.08)

Price = $120

c) Since the intrinsic value of share is more than the current price of snuggli. Hence share is underpriced.

d) As per gordon: P = D1/(Ke-g)

50 = 3.24/(Ke - 0.08)

Ke - 0.08 = 0.0648

Ke = 14.48%

Required rate of return as per gordon is more than required rate of return calculated as per CAPM.