Question

step by step of all equations and explations

1.   (a)       The risk-free rate of return is 8 percent, the required rate of return on the market, E[Rm] is 12 percent, and Stock X has a beta coefficient of 1.4. If the dividend expected during the coming year, D₁, is $2.50 and g = 5%, at what price should Stock X sell?

(b)    Now suppose the following events occur:

1. The Federal Reserve Board increases the money supply, causing the riskless rate to drop to 7 percent.
2. Investors' risk aversion declines: this fact, combined with the decline in R_F, causes R_Mto fall to 10 percent.
3. Firm X has a change in management. The new group institutes policies that increase the growth rate to 6 percent. Also, the new management stabilizes sales and profits, and thus causes the beta coefficient to decline from 1.4 to 1.1.

After all these changes, what is Stock X's new equilibrium price? (Note: D₁goes to $2.52.)

Answer 1

1-A	required rate of return	risk free rate+(market return-risk free rate)*beta	8+(12-8)*1.4	13.6
	terminal value or price of stock	expected dividend/(required return-growth rate)	2.5/(13.6%-5%)	29.07
	stock should sell at			29.07
1-b	required rate of return	risk free rate+(market return-risk free rate)*beta	7+(10-7)*1.1	10.3
	terminal value or price of stock	expected dividend/(required return-growth rate)	2.52/(10.3%-6%)	58.60
	New equilibrium price			58.60