Question

Top hedge fund manager Sally Buffit believes that a stock with the same market risk as the S&P 500 will sell at year-end at a price of $49. The stock will pay a dividend at year-end of $3.00. Assume that risk-free Treasury securities currently offer an interest rate of 2.1%. Average rates of return on Treasury bills, government bonds, and common stocks, 1900–2017 (figures in percent per year) are as follows. Portfolio Average Annual Rate of Return (%) Average Premium (Extra return versus Treasury bills) (%) Treasury bills 3.8 Treasury bonds 5.3 1.5 Common stocks 11.5 7.7

Answer 1

a. 9.80%

b. $47.36

Step-by-step explanation:

a. Discount rate

Discount rate on stock = Risk free rate + Average risk premium on stock

= 2.1% + 7.7%

= 9.80%

b. The price today will be the present value of the stock given the future price and the expected dividends.

= (Future price + dividends) / ( 1 + rate) ^ No. of periods

= (49 + 3) / (1 + 9.8%)

= 52 / 1.098

= $47.36