Question

Ingrid Ilyasova is considering the purchase of the common stock of the Irish Indigo Inc. The most recent dividend paid by the company was $3.78 per share. This dividend is expected to increase at a constant rate of 5.25% indefinitely. Ingrid uses the CAPM to calculate her required rate of return. The current rate on U.S. Treasury securities is 2.78% and the expected rate of return on the stock market going forward is 16.22%. If the beta of the company is 1.17, what is the maximum amount that Ingrid would pay for a share of stock for this company ?

Answer 1

Rf = Risk free rate = US Treasury securities rate = 2.78%

Rm = Expected return on market = 16.22%

Beta = 1.17

Required return = Rf + Beta * (Rm-Rf)

= 2.78% + 1.17*(16.22% - 2.78%)

= 2.78% + 15.7248%

= 18.5048%

g = growth rate = 5.25%

D0 = Most recent dividend = $3.78

D1 = Expected Dividend = D0*(1+g) = $3.78*(1+5.25%) = $3.97845

Stock Price today = D1 / (r-g)

= $3.97845 / (18.5048% - 5.25%)

= $3.97845 / 13.2548%

= $30.0151643

Therefore, maximum amount Ingrid should pay for the company share is $30.02