Question

3. Stock XYZ has a beta of 2.0. The risk-free rate is 1%. The market is expected to return 10% a year before the pandemic hits. The stock is expected to pay a dividend of $1 a year, every year, forever. The pandemic hits. Investors now expect the market to return only 8% a year. The risk-free rate is lowered to 0%, and now the stock is expected to pay a dividend of $0.50 a year, every year, forever. What is the expected percentage change in the price of the stock?

Answer 1

Given about Stock XYZ,

Beta of stock = 2

Before pandemic

Risk free rate Rf = 1%

Market expected return Rm = 10%

Using CAPM, cost of equity = Rf + Beta*(Rm - Rf)

=> Ke = 1 + 2*(10-1) = 19%

Dividend forever D = $1

So, stock price today based on perpetuity model is

P0 = D/Ke = 1/0.19 = $5.26

After Pandemic hit,

Risk free rate Rf = 0%

Market expected return Rm = 8%

Using CAPM, cost of equity = Rf + Beta*(Rm - Rf)

=> Ke = 0 + 2*(8-0) = 16%

Dividend forever D = $0.5

So, stock price today based on perpetuity model is

P0 = D/Ke = 0.5/16 = $3.125

So, percentage change in price = (price after pandemic - Price before pandemic)/price before pandemic

=>  expected percentage change in the price of the stock = (3.125 - 5.26)/5.26 = -40.625%