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Practice Question 14 A firm’s class A common shares are currently trading for $13.70 on the...

Practice Question 14

A firm’s class A common shares are currently trading for $13.70 on the Toronto Stock Exchange. The risk free rate prevailing in the market is currently 5%, the expected return on the market portfolio is 11%. The firm has a beta of 1.6 and is expected to pay a dividend of $2 forever. Under these conditions, the firm’s common shares are currently:

overvalued.

undervalued.

fairly valued.

strongly valued.
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Answer #1

The fair value of the stock is computed as shown below:

= Dividend expected to be paid / required rate of return

Required rate of return is computed as follows:

= risk free rate + Beta x ( return on market - risk free rate )

= 0.05 + 1.6 ( 0.11 - 0.05)

= 14.6% or 0.146

So, the fair value will be:

= $ 2 / 0.146

= $ 13.70 Approximately

So, the stock is fairly valued.

Feel free to ask in case of any query relating to this question

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