Question

The risk-free rate of return is 10%, the required rate of return on the market is 15%, and High-Flyer stock has a beta coefficient of 1.5. If the dividend per share expected during the coming year, D1, is $2.5 and g=5%, at what price should a share sell?

Answer 1

The stock should sell for $20 today.

Step-by-step explanation:

To calculate the price of the stock today, we first need to find out the required rate of return on the stock. We will use the SML equation to find the required rate of return.

r = rRF + beta * (rM - rRF)

Where,

• rRF is the risk free rate
• rM is the return on Market
• beta is the stock's beta

r = 0.1 + 1.5 * (0.15 - 0.1) = 0.175 or 17.5%

As the expected dividend growth of the stock will remain constant at 5%, we will use the constant growth model of DDM.

The formula for price using this model is,

P0 = D1 / r - g

Where D1 is the dividend expected in the next period.

P0 = 2.5 / (0.175 - 0.05)

P0 = $20