Question

2. (8 points) Sure Tool Company is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. The beta of Sure Tool Company's stock is 1.25. a. What is the market's required rate of return on Sure Tool's stocks if CAPM is valid? (4 points) b. If Sure Tool's intrinsic value is $21.00 today, what must be its dividend growth rate? (4 points)

Answer 1

Answer-

Sure Tool Company

Given

Dividend in the upcoming year (D1) = $ 2
Risk free rate (Rf) = 4 %
Market return portfolio (Rm) = 14 %
Beta of stock (B) = 1.25

CAPM

a)

Required rate of return (R) = Rf + B x ( Rm - Rf)

R = 4 % + 1.25 x ( 14 % - 4 %)

R = 4 % + 1.25 x 10%
R = 4 % + 12.5 %
R = 16.5 %

b)

Given

Intrinsic Value = V0 = $ 21
R = 16.5 % = 0.165
D1 = $ 2
Dividend growth rate (G) = ?
V0 = D1 / (R - G)

$ 21 = $ 2 / ( 16.5 % - G)

$ 21 = $ 2 / ( 0.165 - G)

0.165 - G = $ 2 / $ 21

0.165 - G = 0.09524

G = 0.165 - 0.09524

G = 0.06976

G = 6.976 %

The dividend growth rate = G = 6.976 %