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    Using CAPM and CGM, Calculation XYZ's Stock Price

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    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.

    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:
    XYZ's beta (Ã?)
    XYZ's current annual dividend
    XYZ's 3-year dividend growth rate (g)
    Industry P/E
    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:
    Are there any differences?
    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.
    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.
    Why is the present stock price different from the price arrived at using CGM (Constant Growth Model)?

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    Solution Preview

    Please see the attached file.

    CAPM Model
    According to Investopedia.com, the Capital Asset Pricing Model (CAPM) "describes the relationship between risk and expected return and... is used in the pricing of risky securities." The formula used for CAPM is shown below:
    Ke= Rf+B*(Km-Rf)
    ? Ke = Required return on common stock
    ? Rf = Risk-free rate of return; usually the current rate on Treasury bill securities
    ? B = Beta coefficient
    Km = Return in the market as measured by an ...

    Solution Summary

    The solution uses CAPM and CGM to calculate XYZ's stock price.