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Required rate of return and market price of the stock

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1. Rates of return and equilibrium - Stock C's beta coefficient is bc = 0.4, while Stock D's is bd = -0.5. (Stock D's beta is negative, indicating that its return rises when returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.)
a. If the risk-free rate is 7 percent and the expected rate of return on an average stock is 11 percent, what are the required rates on Stocks C and D?
b. For Stock C, suppose the current price, Po, is $25; the next expected dividend , D1, is $1.50; and the stock's expected constant growth rate is 4 percent. Is the stock in equilibrium? Explain, and describe what would happen if the stock is not in equilibrium.

2. Two investors are evaluating GE's stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other holds stocks for 10 years. On the basis of the type of analysis done in this chapter, should they both be willing to pay the same price for GE's stock?

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Solution Summary

This post answers two problems on security valuation. In the first problem, first we calculate the required rates of return on the stocks by using risk free rate and beta and then we evaluate whether the stock is correctly priced in the market or not. The second question is a conceptual question about the required rate of return desired by the two investors. The questions are explained with formula and calculations for easy understanding.

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1. a)
Required rate of return = Risk free rate+ beta*(market return - risk free rate)
Required rate of return on stock C=7%+0.4*(11%-7%)= 8.6%
Required rate of return on ...

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