Question

2. Risk and Valuation. Suppose that a company paid a dividend of $1.75 this year and expects dividends to grow at 5% indefinitely.

a. If the company’s beta is 1.2, the market return is 8%, and the risk-free rate is 2.5%, what is the required rate of return for this company? (5 points)

b. What is the most you should be willing to pay for a share of stock? (10 points)

Answer 1

Required rate of return as per CAPM = Risk free rate + beta*(Market return - risk free rate)

= 2.5% + 1.2*(8%-2.5%)

= 9.1%

b.Value = Expected Dividend next year/(Required return - growth rate)

= 1.75(1.05)/(9.1%-5%)

= $44.8171

i.e. $44.82

Hence, most that will be paid = $44.82