Question

Recently you have received advice from your broker that the stock price of DYP Company is going to rise from the current value of $85.25 per share to $88.50 per share over the next year. The expected cash dividend to be paid by DYP over the next year is $3.00 per share. You are aware that the annual market risk premium is estimated to be 6% and the current 20- year T-bond interest rate is 2.95%. If the beta estimate of DYP is 1.2, will you purchase the stock based on the available information? Select one: O a. No, because it is overvalued. O b. Yes, because the expected return equals the estimated return. c. Yes, because it is undervalued. d. No, because it is undervalued. o e. Yes, because it is overvalued.

Answer 1

a. No, because it is overvalued.

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

А B 1 2 Current price of stock $85.25 3 Estimated price of stock in a year $88.50 4 Cash dividend in one year $3.00 5 Estimated return in a year 7.33% 6 7 T-bond interest rate (risk free) 2.95% 8 market risk premium 6% 9 Beta 1.2 10 Required return of stock 10.15% 11 12 Required return of stock is greater than estimated return thus 13 this stock is overvalued and not recommended to purchase. 14

Cell reference -

A 1 2 Current price of stock 85.25 3 Estimated price of stock in a year 88.5 4 Cash dividend in one year 5 Estimated return in a year =((B3-B2)+B4)/B2 6 7 T-bond interest rate (risk free) 0.0295 8 market risk premium 0.06 9 Beta 1.2 10 Required return of stock =B7+B9*B8 11 12 Required return of stock is greater than estimated return thus this stock is 13 overvalued and not recommended to purchase. 14 15

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.