Assume the risk-free rate of return is 6%, the expected rate of return on the ma
ID: 2801901 • Letter: A
Question
Assume the risk-free rate of return is 6%, the expected rate of return on the market portfolio is 13%, and the beta of Psy Corp. is 1.3. Psy has earnings of $8 per share that are expected to grow 5% a year and pays them all out to stockholders.
A) What is the value of a share of Psy?
B) Assume Psy has an investment opportunity that will yield a return of 20% and decides to reduce the dividend payout ratio to 50% and devote the rest of their earnings to the investment. Calculate the new value of Psy stock.
C) Assume you buy the stock at a price of $70 and expect to sell it in a year. If the stock’s market price is at its intrinsic value in one year, what is your expected holding period return on the stock (using the assumptions in part B)?
Explanation / Answer
Answer a) Cost of equity = Risk free rate + Beta * (Market return - Risk free rate )
= 6% + 1.3*(13%-6%) = 15.10%
Price of stock = 8%*(1.04) / (15.1%-5%) = 83.16832
Answer b)
Price of stock = Expected Dividend / (15.1%-5%)
= 8*50%*(1.05) / (15.1%-5%)
= 41.584
Answer c) Holding period return =( Final Price - Intial Price + Dividend Paid ) / Intial Price
HPR = (41.584-70 + 4.2) / 70 = -34.59%