Question

You estimate the beta of a preferred stock you’re considering buying at 1.2. The risk free rate is 3% currently and the market is expected to return investors 8% (over the long run, maybe not tomorrow!). The preferred dividend is $140 per year per share. If it turns out that the beta of the stock is 1.0, what is likely to happen to the value of your investment? By how much, exactly?

Answer 1

Estimated required return = risk-free rate + [Estimated Beta * (Expected Market Return - Risk-free rate)]

= 3% + [1.2 * (8% - 3%)] = 3% + [1.2 * 5%] = 3% + 6% = 9%

Estimated Stock Price = Preferred Dividend / Estimated required return = $140 / 0.09 = $1,555.56

Actual required return = risk-free rate + [Actual Beta * (Expected Market Return - Risk-free rate)]

= 3% + [1.2 * (8% - 3%)] = 3% + [1 * 5%] = 3% + 5% = 8%

Estimated Stock Price = Preferred Dividend / Estimated required return = $140 / 0.08 = $1,750

Value of Investment will increase by $194.44 ($1,750 - $1,555.56)