Question

An investor expects a stock to sell for $100 in exactly one year. The stock will not pay a dividend in the next year. After some research, the investor estimates the firm's beta as 1.20, the risk free rate at 2%, and the market portfolio risk premium at 5.50%. Given this information and expected price, how much can the investor pay today for this stock to earn his required return?

Answer 1

As per CAPM,

$Required Rate of Return= R_f +\beta (R_{mp})$ where, Rf= Risk Free Return=2%

Rml= Market Risk Premium=5.50%

B= beta=1.2

Required Rate of Return= 2% + 1.2(5.5%)

=8.6%

Expected Price of Stock in one year(P1) =$100

As stock will not pay dividend in the next year and investor expects to earn the required return in one year.

So, Current Price = P1/(1+r)^1

=$100/(1+0.086)^1

= $92.08

So, investor must pay $92.08 today to earn required return