Question

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Problem 11-06

The risk-free rate of return is 1 percent, and the expected return on the market is 9 percent. Stock A has a beta coefficient of 1.5, an earnings and dividend growth rate of 3 percent, and a current dividend of $2.80 a share. Do not round intermediate calculations. Round your answers to the nearest cent.

$  

The stock -Select-shouldshould notItem 2 be purchased.

$  

$  

$  

The increase in the return on the market -Select-increasesdecreasesItem 6 the required return and -Select-increasesdecreasesItem 7 the value of the stock.

The increase in the risk-free rate and the simultaneous increase in the return on the market cause the value of the stock to -Select-increasedecreaseItem 8 .

The decrease in the beta coefficient causes the firm to become -Select-lessmoreItem 9 risky as measured by beta, which -Select-increasesdecreasesItem 10 the value of the stock.

1. What should be the market price of the stock?
2. If the current market price of the stock is $8.00, what should you do?
3. If the expected return on the market rises to 14.8 percent and the other variables remain constant, what will be the value of the stock?
4. If the risk-free return rises to 3.5 percent and the return on the market rises to 15.2 percent, what will be the value of the stock?
5. If the beta coefficient falls to 1.4 and the other variables remain constant, what will be the value of the stock?
6. Explain why the stock’s value changes in c through e.

Answer 1

11-06
a. Required rate of stock =Risk Free rate + Beta*(Market return-Risk Free Rate) =1%+1.5*(9%-1%) =13%
Market Price of Stock =D0*(1+g)/(Required Rate-growth) =2.80*(1+3%)/(13%-3%) =28.84

b. If current price of 8 is less than the value of stock of 28.84. The stock should be purchased.

c. Value of the stock decreases if market return rises to 14.8% as required rate increases
Required rate of stock =Risk Free rate + Beta*(Market return-Risk Free Rate) =1%+1.5*(14.8%-1%) =21.70%
Market Price of Stock =D0*(1+g)/(Required Rate-growth) =2.80*(1+3%)/(21.70%-3%) =15.42

d. If Risk free rate and market return increases required rate of increases and hence price of stock decreases.
Required rate of stock =Risk Free rate + Beta*(Market return-Risk Free Rate) =3.5%+1.5*(15.2%-3.5%) =21.05%
Market Price of Stock =D0*(1+g)/(Required Rate-growth) =2.80*(1+3%)/(21.05%-3%) =15.98