THEORETICAL STOCK PRICES
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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%.
â?¢Download the XYZ Stock Information by clicking the link.
â?¢Using the information from the XYZ Stock Information document, record the following values:
â-¦XYZ's beta (Ã?)
â-¦XYZ's current annual dividend
â-¦XYZ's 3-year dividend growth rate (g)
â-¦Industry P/E
â-¦XYZ's EPS
â?¢With the information you recorded, use the CAPM to calculate XYZ's required rate of return (ks).
â?¢Use the CGM to find the current stock price for XYZ. We will call this the theoretical price (Po).
â?¢Now use the XYZ Stock Information to find XYZ's current stock quote (P). Compare Po and P and answer the following questions:
â-¦Are there any differences?
â-¦What factors may be at work for such a difference in the two prices?
â?¢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.
â-¦What will the new price be? Explain.
â?¢Recalculate XYZ's stock price using the P/E ratio model and the needed info found in the XYZ Stock Information file.
â-¦Why is the present stock price different from the price arrived at using CGM (Constant Growth Model)?
â?¢If you used Microsoft Word to arrive at your answers, then you must provide an explanation of the formulas and calculations.
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Solution Summary
THEORETICAL STOCK PRICES AND HOW THEY REACT TO MARKET FORCES
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An estimation of the 10 year treasury rate is 2.558%, found here http://finance.yahoo.com/q?s=%5ETNX.
For simplicity, we assume it is 2.6%.
60 month beta = 1.64
Current Annual dividend = 0.8
3 year div. growth = 8.2%.
Industry P/E = 23.2
XYZ's P/E = 15.65.
By CAPM, we know that E(stock) = rf + beta(market risk premium) = 0.026 + 1.64 X 0.075 = 14.9%, this is the company's required rate ...
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