Question

Please provide in great deal as I need to understand this

4. You are considering the purchase of a share of stock. In the most recently reported fiscal year Earnings per Share (EPS) were $1.75. You expect earnings to grow at 0.85% per year into the future, and you require a return of 8% on the investment. Using a Gordon Growth Model (PLEASE EXPLAIN WHAT THIS MODEL IS), what is a reasonable estimate for the share price?

5. You are considering the purchase of a stock with a Beta of 0.95. The current yield on T-Bonds is 1.65%, and you expect the long-term excess returns on the Market Portfolio to be 6.55%. Use the Capital Asset Pricing Model (CAPM) to estimate the long-term return on this stock.

Answer 1

4) Gordon Growth Model is also known as dividend discount model, which is used to estimate stock prices.

Price, P = D0 x (1 + g) / (r - g)

where, D0 - Current Dividend, g - expected growth rate, r - required returns

Price = 1.75 x (1 + 0.85%) / (8% - 0.85%) = $24.68

Note - Dividends are not given in this case and we assume that all earnings would be paid out as dividends, i.e. the payout ratio is 100%.

5) Using CAPM, Returns, r = rf + beta x rp

where, rf - risk-free rate = 1.65%, beta = 0.95, and rp - risk premium or excee returns = 6.55%

=> Returns = 1.65% + 0.95 x 6.55% = 7.8725%