Question

Suppose you have the following information, Rf= 3%, the beta of a company X is 1.35 and the risk premium is 8.5%. Currently, this company’s stock price is $35 and a prominent analyst expects the price to be $39.50 in one year. Also, this company is expected to pay a dividend of 1.25 during the year. What is the company’s return using CAPM and what is the expected return of the analyst? a) 14.48%; 16.43% b) 16.43%; 15.12% c) 14.48%; 12.74% d) 11.36%; 15.74% e) 12.58%; 13.69%

Answer 1

Return using the CAPM Approach

As per CAPM Approach, the Required Rate of Return = Risk-free Rate + (Beta x Risk Premium)

= Rf + (Beta x Risk Premium)

= 3.00% + (1.35 x 8.50%)

= 3.00% + 11.48%

= 14.48%

Expected return of the analyst

Expected Rate of Return = [(Changes in the share price + Dividend Received) / Share Price at the beginning] x 100

= [{($39.50 - $35.00) + $1.25} / $35.00] x 100

= [($4.50 + $1.25) / $35.00] x 100

= [$5.75 / $35.00] x 100

= 16.43%

“Therefore, the return using CAPM and the expected return of the analyst would be (a) 14.48%; 16.43%”