Question

•HSCC, a wholly owned subsidiary of Novel Inc. has a beta of 1.2 when computed against the market portfolio
•One year from now, this subsidiary has a 0.8 probability of being worth $18 per share and a 0.2 probability of being worth $38 per share
•The risk-free rate is 4% per year
•The market portfolio has an expected return of 9% per year
•What is the present value of a share of HSCC, assuming no dividend payments to the parent firm in the coming year?

Answer 1

The present value of the share will be calculated using dividend discount model, given by:

p = Expected stock price / (Expected Rate of return)t

t is the time period (1 year in our scenario)

Expected stock price can be calculated as:

E (P) = 0.8 * 18 + 0.2 * 38 = $22

Now, we have calculate the expected rate of return (R) using the Capital Asset Pricing model (CAPM):

CAPM is given by:

Required return (R) = Rf + (Beta) * (Rm – Rf)

Rf is the risk-free rate of return

Rm is the expected market return

Using the values provided in the question in the CAPM formula, we get:

R = 4% + 1.2 * (9% - 4%) = 10%.

This is the Expected Rate of Return which will be used in the Dividend Discount formula:

P = 22 / (1+0.1) ¹

Thus, P = $20.