Question

Your firm’s earnings this period are $5 per share. It’s beta is 1.75. The expected returns...

Your firm’s earnings this period are $5 per share. It’s beta is 1.75. The expected returns on T-bills and the S&P 500 are 2.5% and 11% respectively. If you decide to reinvest 20% of earnings into projects providing a 10% return:

a. How much should you expect pay for one share of this stock?

b. If the stock is currently selling for $45, is this a good investment? Why or why not?

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Homework Answers

Answer #1

Growth Rate = ROE * Retention Ratio

= 10% * 20%

= 2%

D0 = $ 5 * (1-0.20)

= 5 * 0.80

= $ 4

Required Rate of Return =

= 2.5% + 1.75(11% - 2.5%)

= 17.375%

Value of Stock =

=

= 4.08 / 0.15375

= $ 26.54

If the stock is currently priced at 45 then the stock is over-valued. When the stock is over-valued the stock is sold, not bought.

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