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Capital Asset Pricing Model and Constant Growth Model

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Details: By walking through a set of financial data for XYZ, this assignment will help you better understand how theoretical stock prices are calculated and how prices may react to market forces such as risk and interest rates. You will use both the CAPM (capital asset pricing model) and the constant growth model (CGM) to arrive at XYZ's stock price.

To receive full credit on this assignment, please show all work, including formulae and calculations used to arrive at financial values.

Guidelines:
- Find an estimate of the risk-free rate of interest (krf). To obtain this value, go to Bloomberg.com: Market Data and use the "U.S. 10-year Treasury" bond rate (middle column) as the risk-free rate. In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 7.5%.
- Download the XYZ Stock Information by clicking the link.
- Using the information from the XYZ Stock Information document, record the following values:
o XYZ's beta (Ã?)
o XYZ's current annual dividend
o XYZ's 3-year dividend growth rate (g)
o Industry P/E
o XYZ's EPS
- With the information you recorded, use the CAPM to calculate XYZ's required rate of return (ks).
- Use the CGM to find the current stock price for XYZ. We will call this the theoretical price (Po).
- Now use appropriate Web resources to find XYZ's current stock quote (P). Compare Po and P and answer the following questions:
o Are there any differences?
o What factors may be at work for such a difference in the two prices?
- Now assume the market risk premium has increased from 7.5% to 10% and this increase is due only to the increased risk in the market. In other words, assume the krf and the stock's beta remain the same for this exercise.
o What will the new price be? Explain.
- Recalculate XYZ's stock price using the P/E ratio model and the needed info found in the XYZ Stock Information file.
o Why is the present stock price different from the price arrived at using CGM (Constant Growth Model)?

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Solution Preview

1. Find an estimate of the risk-free rate of interest, krf. To obtain this value, go to Bloomberg.com: Market Data [http://www.bloomberg.com/markets/index.html] and use the "U.S. 10-year Treasury" bond rate as the risk-free rate. In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 7.5%.

Government Bonds
COUPON MATURITY PRICE/YIELD PRICE/YIELD CHANGE TIME
US 10-Year 2.625 11/15/2020 93-17½ / 3.40 0-11½ / -0.045 01/21
Australia 10-Year 5.750 05/15/2021 100.73 / 5.65 -0.743 / 0.095 01/21
Brazil 10-Year 10.000 01/01/2021 853.48 / 12.61 -9.145 / -0.102 16:27
Germany 10-Year 2.500 01/04/2021 94.31 / 3.18 -0.098 / 0.012 01/21
Japan 10-Year 1.200 12/20/2020 99.93 / 1.22 -0.036 / 0.004 04:53
UK 10-Year 4.750 03/07/2020 108.10 / 3.70 -0.067 / 0.008 01/21

Go to the website and collect the information about U.S. 10-Year Treasury. Thus, the risk free rate is 2.625%.

2. Download this XYZ Stock Information document (.pdf file). Please note that the following information contained in this document must be used to complete the subsequent ...

Solution Summary

The solution uses both the CAPM and the CGM to arrive at XYZ's stock price.

$2.19