Question

You believe that EastX.plc company will be worth £100 per share one year from now. How much are you willing to pay for one share today if the risk free rate is 8%, the expected rate of return on the market is 18%, and the company’s beta is 2.0? State clearly any assumptions you made in your calculations.

Answer 1

The amount that you will be ready to pay should be the present value of the future stock price. We need Required return of equity in order to discount the stock to its present value.

The required return on equity can be found using Capital Asset Pricing Model

Required return on equity = Risk Free rate + Beta ( Market Return - Risk Free Rate)

= 8 + 2 ( 18 - 8)

= 28%

So the present value of the stock should be = Future Value / (1 + Required equity Return)

= 100 / ( 1 + 28%)

= 78.125

So an investor should be willing to pay $78.125 for a stock whose future value after 1 year is $100.

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