Question

1. 5,Consider three stocks: Q, R and S.

	Beta	STD (annual)	Forecast for Nov 2008
			Dividend	Stock Price
Q	0.45	35%	$0.50	$45
R	1.45	40%	0	$75
S	-0.20	40%	$1.00	$20

Q5. See the table above:

Use a risk-free rate of 2.0% and an expected market return of 9.5%. The market’s standard deviation is 18%. Assume that the next dividend will be paid after one year, at t = 1.

1. According to the CAPM, what is the expected rate of return of each stock?
2. What should today’s price be for each stock, assuming the CAPM is correct?

Answer 1

Solution

The required return is given by CAPM as

E[r]= Risk_Free_Rate + beta*(Market_Return - Risk_Free_Rate)

For Stock Q:

E[r]= 0.02+0.45*(0.095-0.02)

= 0.05375 or 5.375%

For Stock R:

E[r]= 0.02+1.45*(0.095-0.02)

= 0.12875 or 12.875%

For Stock S:

E[r]= 0.02-0.20*(0.095-0.02)

= 0.005 or 5.000%

QUESTION B

The Gordon has given a model for uneven dividends which has terminal price. It is given as

P₀ = D1/(1+r) + P1/(1+r)

P1 & D1 are next year price and dividends

Where r is the expected return. we have to use this r from above answers for each stock.

For Stock Q:

P₀ = 0.5/(1+0.05375) + 45/(1+0.05375)

= $ 43.1791221827

For Stock R:

P₀ = 0.0/(1+0.12875) + 75/(1+0.12875)

=$ 66.4451827243

For Stock S:

P₀ = 1.0/(1+0.005) + 20/(1+0.005)

=$ 20.8955223881