Question

1. Assume that the market risk premium now is 6% and the risk-free return is 1%. Using this given information and Emerson’s beta as published by Reuters (1.5) , please use the CAPM and compute the required rate of return for Emerson. (Please note that you are given the market-risk premium here, not the market return! Please explain the meaning of beta, and the required rate of return as part of your answer.)
2. Assuming a constant growth rate model and using the 3-year dividend growth rate (provided by Reuters - Keymetrics - Growth) please compute the expected stock price for Emerson. Write down the formula you are using and explain your answer briefly. In the light of what you found, can we say that Emerson’s stock price is fair?
3. Assume that the unanticipated inflation caused the security-market line to shift upwards 1 percentage point. Will you modify your answer in (5) above? Explain.
4. If market risk premium increases 1 percent, will you modify your answer in (5) above?

Share Price: 47.37

Answer 1

Using CAPM, required rate of return for Emerson:

Re= Rf+(Rm-Rf) Beta

Where, Rf= risk free rate

Rm-Rf= risk premium

Beta= 1.42 (as per Reuters report)

hence, Re= 1+ (6*1.42)= 9.52%

Also, Beta represents the sensitivity of the stock's return to market return. In this case, beta of 1.42 means that when the market return changes by 1%, then Emerson's stock return changes by 1.42%. Hence, this is an aggressive stock.

Required return of 9.52% means that the shareholders of Emerson will require a minimum return of 9.52% in lieu of their investment.