Question

A share of stock sells for $35 today. The beta of the stock is 1.2 and the expected return on the market is 12 percent. The stock is expected to pay a dividend of $.08 in one year. If the risk-free rate is 5.5 percent, what should the share price be in one year?

Answer 1

Answer:

The share price after one year will be $39.57.

Explanation:

First of all, we have to calculate the Expected Return or Cost of Equity using CAPM. Below given is the equation of CAPM:

                  E(R) = Risk Free Rate + Beta (Market Risk - Risk Free Rate)

When we put values in the above equation, we get .1330. The is the expected return that the under-study stock can provide to its investors.

The Expected Return or simply return is composed of two ingredients: Dividend Yield and Capital Gain Yield. We will be compounding the Current Stock using the Capital Gain Yield to find Stock Price after one year because it is the return that arises from stock price differences.

                          Dividend Yield = .08/35 = .0023

Deduct Dividend Yield from Total Yield to get Capital Gains Yield.

                   Capital Gains Yield = .1330 - .0023 = .1307.

This implies that the Stock Price after one year will be:

P1 = 35 (1 + .1307) = $39.57.

Thank you!