Question

Stock X’s beta is 1.8, the nominal risk-free rate is 2.4 percent, and the expected rate of return on an average stock is 12 percent. The current price for Stock X is $8. The dividend that was just paid was $0.80, and the stock’s expected constant growth rate is 8 percent. Should Larson buy this stock? (Calculate the equilibrium value of the stock and decide if it’s worth $8.)

Answer 1

As per CAPM,

where, rf = Risk free return = 2.4%

Rm = Market Return = 12%

Beta = 1.8

Required Return = 2.4% + 1.8(12%-2.4%)

Required Return = 19.68%

- Calculating the Current price of stock using Required Return:-

where, D0 = Dividend just paid = $0.8

g = growth rate of dividend = 8%

ke = Required Return = 19.68%

P0 = $7.40

Price when Required Return of 19.68% is $7.40

So, fair Value of stock is $7.40 while stock is currently trading at a higher price of $8

Thus, Stock should not be Buyed as it is overvalued.

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