Question

You are considering two stocks. Both pay a dividend of $1, but the beta coefficient of A is 1.5 while the beta coefficient of B is 0.7. Your required return is

                                                      k = 8% + (15% - 8%) B.

a.) What is the required return for each stock?

b.) If A is selling $10 a share, is it a good buy if you expect earnings and dividends to grow at 5 percent.

c.) The earnings and dividends of B are expected to grow annually at 10 percent. Would you buy the stock for $30?

d.) If the earnings and dividends of A were expected to grow annually at 10 percent, would it be a good buy at $30?

Answer 1

a). K(Stock A) = 8% + (15% - 8%)1.5 = 8% + 10.5% = 18.5%

K(Stock A) = 8% + (15% - 8%)0.7 = 8% + 4.9% = 12.9%

b). P(Stock A) = [D0 x (1 + g)] / [r - g]

= [$1 x 1.05] / [0.185 - 0.05] = $1.05 / 0.135 = $7.78

No. it is not a good buy, as its fair price is less than the selling price.

c). P(Stock B) = [D0 x (1 + g)] / [r - g]

= [$1 x 1.10] / [0.129 - 0.10] = $1.10 / 0.029 = $37.93

Yes. it is a good buy, as its fair price is greater than the selling price.

c). P(Stock A) = [D0 x (1 + g)] / [r - g]

= [$1 x 1.10] / [0.185 - 0.10] = $1.10 / 0.085 = $12.94

No. it is not a good buy, as its fair price is less than the selling price.