Question

Question
Broken just paid annual dividends of R2, has beta of 1.3, and a growth rate of 6% for the foreseeable future. The current return on the market is 10%, and Treasury bills earn 4%.
Required
If the rate on Treasury bills drops by 0.50% and market premium increases by 1.0%, what growth rate would keep Broken’s stock price constant? [12 Marks]

Answer 1

Applying CAPM equation:

Rate of return = Risk free rate + Beta x (Market return - Risk free rate)

Rate of return = 4% + 1.3 x (10% - 4%)

Rate of return = 11.80%

Now,

Expected dividend / Price of share = Rate of return – Growth rate

Expected dividend / Price of share = 11.80% - 6%

Expected dividend / Price of share = 5.80%

----

Market risk premium = 10%-4% + 1% = 7%

Using CAPM for revised return:

Revised of Return = 3.50% + 1.3 x 7%

Revised of Return = 12.60%

Now,

Expected dividend / Price of share = Revised rate of return - Revised Growth rate

5.80% = 12.60% - Revised Growth rate

Revised Growth rate = 6.80%