Question

A share of stock with a beta of 0.75 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4%, and the market risk premium is 7%. a. Suppose investors believe the stock will sell for $52 at year-end. Calculate the opportunity cost of capital. Is the stock a good or bad buy? What will investors do?

Answer 1

Answer:

What the investors will do depends on whether the actual return will be higher, lower or the same as the required return (Opportunity cost of capital) .

The Actual return can be calculated using the Holding Period Return which is;

= (Earnings(Dividends) + (Ending Stock Price - Beginning Stock Price))/Beginning Stock Price

= (2 + (52 - 50))/50

= 4/50

= 8%

The Opportunity Cost of Capital can be calculated using CAPM.

= Risk Free Rate + beta(Market Premium)

= 4% + 0.75(7%)

= 9.25%

The Opportunity Cost of Capital is greater than the Actual Return from the stock so the stock is a bad buy.

Investors will not invest.