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Calculating Risk and Capital Using CAPM and CGM Models

Please show all work, and references used. There is an attachment which information from the pdf must be used for the calculations. Thanks!

By walking you through a set of financial data for IBM, 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 IBM's stock price. To get started, complete the following steps.

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.

From website-U.S. 10-year Treasury Bond rate is
U.S. 10-Year Treasury 3.34 -0.05

In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 7.5%.

2. Download this IBM Stock Information document (.pdf file). (Attached) Please note that the following information contained in this document must be used to complete the subsequent questions.
1. IBM's beta (ß)
2. IBM's current annual dividend
3. IBM's 3-year dividend growth rate (g)
4. Industry P/E
5. IBM's EPS.

3. With the information you now have, use the CAPM to calculate IBM's required rate of return or ks.

4. Use the CGM to find the current stock price for IBM. We will call this the theoretical price or Po.

5. Now use appropriate Web resources to find IBM's current stock quote, or P. Compare Po and P. Do you see any differences? Can you explain what factors may be at work for such a difference in the two prices? This section is especially important - with more weight in grading - so you may want to do some study before answering such a question. Explain your thoughts clearly.

6. 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 krf and stock's beta remains the same for this exercise. What will the new price be? Explain what happened.
7. Recalculate IBM's stock using the P/E ratio model and the needed info found in the IBM pdf file. Explain why the present stock price is different from the price arrived at using CGM (Constant Growth Model).


Solution Preview

Discussion of basics:

As per the cbdd, The cost of equity capital is equal to the required rate of return on equity-supplied capital. Hence cost of equity represents the opportunity cost of the shareholders. We will find the rate for cost of equity by using various models. These are described below:

Cost of equity using dividend growth model
AS per Investopedia "DDM demonstrates the underlying principle that a company is worth the sum of its discounted future cash flows. " Here the dividends are taken as a ...

Solution Summary

Response provide the steps of Calculating Risk and Capital Using CAPM and CGM Models