3) Jim Bob is a stock picking genius. Every year, based on his system, he has the ability to invest $100 (only) in a security that is expected to earn a 20% return over the next year. That security always has a beta of one. Assume that the risk free rate is 4%, and the market risk premium is 6%. Assume that Jim Bob organized his trading company as a corporation, and has one share of stock outstanding and no debt. The gains from his security trading every year are paid out as dividends, so he always invests $100, and he can pass his techniques on to his kids, so Jim Bob's firm is expected to last in perpetuity. Ignore taxes.
a) What is the NPV of his trading opportunity each year? Should he buy the security every year?
b) Assume that he does buy the security every year. What is a fair market price for the one share of stock in Jim Bob's company? If you buy the share of stock (in Jim Bob's firm) at this price, what annual return should you expect to earn?
a) Cost of capital = risk free rate + beta*market risk premium = 4%+1*6%=10%
Cash flows associated with trading opportunity
year Cash flow
This solution provides an explanation on how to determine the NPV of a trading opportunity.