Question

The current risk-free rate is 3 percent and the market risk premium is 4 percent. You are trying to value ABC company and it has an equity beta of 0.8. The company earned $1.50 per share in the year that just ended. You expect the company's earnings to grow 5 percent per year. The company has an ROE of 10 percent.

Answer 1

Risk free rate. Rf = 3% Market risk premium, Rm - Rf = 4% Beta = 0.8 = Required return of stock as per CAPM. RR Rf+ Beta * (Rm - Rf) = 3% + 0.8 * 4% = 3% + 3.2% = 6.2% Expected earnings in current year. E0 = $1.50 Growth rate, g = 5% ROE 10% E1 = E0 *(1 +9) $1.50 * (1 + 5%) = $1.575 = Growth rate = Retention ratio * ROE 5% = Retention ratio * 10% Retention ratio = 5%/10% = 0.50 Payout ratio = 1 - Retention ratio 1 -0.50 = 0.50 D1 E1 * Payout ratio = $1.575 * 0.50 = $0.7875 Value of stock = D1 / (RR - g) = $0.7875/(6.2% - 5%) = $65.625 Ans : $65.625 Per share