Question

Angus Corporation paid a dividend of $1.25 per share last year. Dividends are expected to grow at a rate of 5% per year into the foreseeable future. 1) Assume the current Treasury security rate is 4% and the average S&P 500 market return is 8%. ValueLine is reporting a beta of 1.35 for Angus. How much do you think a share of Angus stock is worth? 2) If Angus’ shares are currently selling for $35, what is the expected rate of return on the stock? Should you buy it? Explain.

Answer 1

Given about Angus Corporation,

Last dividend D0 = $1.25

dividend growth rate g = 5%

1). risk free rate Rf = 4%

market return Rm = 8%

Beta of Angus = 1.35

So, required rate of return using CAPM model is

Required rate of return r = Rf + beta*(Rm - Rf) = 4 + 1.35*(8-4) = 9.4%

So, stock's price today using Constant dividend growth model is

P0 = D0*(1+g)/(r - g) = 1.25*1.05/(0.094-0.05) = $29.83

So, expected stock price is $29.83.

2). When current stock price P0 = $35

expected return on stock is using constant dividend growth model is

E(r) = D0*(1+g)/P0 + g = 1.25*1.05/35 + 0.05 = 8.75%

So, expected return on the stock is 8.75%

When expected return on stock is less than required rate of return, it is plotted below the security market line and hence it is overvalued now. Since it is overvalued, its price is expected to decrease in near future. So, stock should not be bought.