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Portfolio Expected Rate of Return and Beta and the Constant Dividend Growth Model

Monica Dubois, an ABC investment advisor, has a new client, Mr. Jack Klein. Mr. Klein is a conservative investor who is interested in a required rate of return of 10% on his stock investments while assuming lower market risk. You are asked to help Monica make a suitable portfolio recommendation backed by risk-return calculations. The 3 possible stock choices for Mr. Klein and their respective betas are as follows:

(see attached file for data)

Part I
Determine the expected returns and beta for a portfolio consisting of one third of Mr. Klein's funds in each stock.

Part II
Assume the following:
- Each ABC stock pays current dividends of $1.50 annually with 6% expected annual increases. The current market stock price for ABC is $30 per share.
- Each XYZ stock pays current dividends of $1.75 annually with 6% expected annual increases. The current market stock price for XYZ is $27 per share.
- Each WHY stock pays current dividends of $2.25 annually with 7% expected annual increases. Current market stock price for WHY is $35 per share.

Complete the following for this assignment:
- Using the constant dividend growth model, determine whether ABC and WHY are over- or undervalued.
- For what types of companies is the constant growth model an appropriate analysis tool?
- What are the limitations of the constant growth model?

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Solution Summary

The portfolio expected rate of return can be used to determine the best portfolio component stocks for an investor. The portfolio beta can be used to determine the beta for the portfolio of component stocks. The constant dividend growth model can be used to determine the value of a stock based on a constant dividend rate, dividend amount and investor's required rate of return.

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