Question

Low Cost Airline is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return
is 4% and the expected return on the market portfolio is 14%. Analysts expect the price of Low Cost
Airline shares to be $22 a year from now. The beta of the company's stock is 1.25. Based on the above
information answer questions

The market's required rate of return on Low Cost’s stock?

What is the intrinsic value of Low Cost’s stock today?

If Low Cost’s intrinsic value is €21.00 today, what must be its growth rate?

Answer 1

RE is cost of equity or required rate of return

RE = RF + (RM - RF)*B

where RF is risk free rate = 4%

RM is market portfolio rate = 14%

B is stock beta = 1.25

(a) Therefore, RE = 4 + (14-4)*1.25

= 4 + 12.5

=16.5%

(b) Intrinsic Value or Present Value (PV) = (for known future price)

where D1 is Dividend next year = 2

P1 is Price next year = 22

RE = 16.5% or 0.165

T is no. of years = 1

Therefore, PV = (2+22)/(1+ 0.165)

= 24/1.165

= 20.6009

= 20.60

(c) Growth rate is calculated when dividends grow each year and future price is unknown

Growth rate, g = R_E - (D1/P)

where P is price of stock today = 21

Therefore, g = 0.165 - 2/21

= 0.06976 or 6.98%