# THEORETICAL STOCK PRICES

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 Preview

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 ...

#### Solution Summary

THEORETICAL STOCK PRICES AND HOW THEY REACT TO MARKET FORCES