Question

LA Diversified Inc. recently paid its annual dividend of $3. Dividends have consistently grown at a rate of 3.8%. The stock has a beta of 1.29. The current risk-free rate is 2% and the market return is 10%. Assuming that CAPM holds, what is the intrinsic value of this stock?a. $35.22b. $36.55c. $37.22d. $39.74e. $35.84

Answer 1

Answer:

The intrinsic value of the stock is $36.55 and option B is the correct answer.

Explanation:

Using the CAPM, we can calculate the required rate of return on the stock which is the minimum return required by the investors to invest in the stock.

r = rRF + Beta * (rM - rRF)

Where,

• rRF is the risk free rate
• rM is the return on market

r =  0.02 + 1.29 * (0.1 - 0.02)   =  0.1232 or 12.32%

The stock's dividend growth is constant. Thus, the current price or intrinsic value of such a stock can be calculated using the constant growth model of the DDM. Th formula for price under the constant growth model is,

P0 = D1 / r-g

Where,

• D1 is the dividend expected for the next period or D0 * (1+g)
• r is the required rate of return
• g is the growth rate in dividends

P0 = 3 * (1+0.038)  /  (0.1232 - 0.038)

P0 = $36.549 rounded off to $36.55