What is the expected return of the given stock

Reference no: EM131960714

Question: Consider an economy where CAPM holds, and where the risk-free rate is Rf = 2%, the expected return on the market portfolio is ERm = 12%, and the standard deviation of the return on the market portfolio is sm = 30%. The covariance between the return of ABC stock and the return of the market portfolio is equal to 0.18. All of this data refers to annual returns.

(a) What is the expected (annual) return of ABC stock?

(b) If ABC's dividends equal $10 per share next year and grow at a rate of 12% per year subsequently, what is the current price per share of ABC stock?

(c) Now suppose that the dividend growth of ABC depends on the success of a clinical trial for their product. If the trial is successful, dividend growth will be 17%. If the trial is unsuccessful, dividend growth will be 7%. The trial is successful with probability 50%. The success of the trial is uncorrelated with the return on the market portfolio (which is to say that the beta of ABC is the same as before). Next year's dividend will be $10 irrespective of the outcome of the trial. What should be the share price of ABC stock in this environment? Hint: compute the share price when G = 7% with certainty, and when G = 17% with certainty, then compute the expected price knowing the fact that both outcomes are equally likely.

(d) Compare your answers to (b) and (c). Which one is higher? Explain the intuition behind this result.

(e) Use the analysis in this example to evaluate the argument that technology companies had such high prices in the late 1990s partly because of uncertainty about the success of new technologies used by them. Based on the example, is this argument plausible?

Reference no: EM131960714

Questions Cloud

Elasticity of supply of ronaldo''s services : What can you say about the elasticity of supply of Ronaldo's services and his supply of labor curve?

Amount of safety equipment : In a world of zero transaction costs, what will the effect of changing liability for accidents be due to the amount of safety equipment in a coal mine?

What is the hard part of this collusive agreement : a. What is the "hard" part of this collusive agreement? Explain. b. Do you think it would be "easier" or "harder" if it were the "Organization of the Wheat

Demonstrate the ability to apply statistical tools : Demonstrate the ability to apply statistical tools and techniques to solve problems to improve business decision-making process.

What is the expected return of the given stock : Consider an economy where CAPM holds, and where the risk-free rate is Rf = 2%, the expected return on the market portfolio is ERm = 12%.

Find the actual price an investor has to pay : Find the actual price an investor has to pay upon settling the transaction of buying a bond given that interest has accrued until March 6.

Intellectual reaction to problems of the times : Some historians hold that economic theory can be explained as an intellectual reaction to problems of the times.

What is the profit or loss on the call : Consider a call option on BMI Corp. with a strike price of $97 and a premium of $2.25. What is the profit or loss on the call just prior to expiration.

Activities of the rising capitalist class : The success of Adam Smith is explained by the fact that his theories rationalized the activities of the rising capitalist class. Explain.

User Account

All Pages