Question

QUESTION 5 Coca Cola stock is currently selling for $51.40 a share. It is expected to reach a price of $53.20 a year from now. You expect the company to pay a dividend of $1.40 in the next year and the stock's beta is 0.66. The risk-free rate of return is 3.5% and the market rate of return is 11.5%. CAPM states that: RR = RF + B(RM-RF). d. Based solely on your computations, should you invest in Coca Cola stock? Explain, making reference to any relevant data.

Answer 1

Current Selling Price (P0) = $ 51.40

Expected price in one year (P1) = $ 53.20

Dividend next year (D1) = $ 1.40

Holding Period Return = $=\frac{(P_{1}-P_{0}) +D_{1}}{P_{0}}$

  $=\frac{(53.20-51.40)+1.40}{51.40}$

= 6.23%

As per CAPM,

$Required Return= R_{f}+\beta (R_{m}-R_{f})$

Rf = Risk free Return = 3.5%

Rm = Market return = 11.5%

Beta of Stock = 0.66

Required Return = 3.5% + 0.66(11.5% - 3.5%)

= 8.78%

As, Required Return as per CAPM is higher than that of Holding Period return, the stock is currently overpriced and you should not invest in the company.

If you invest in the company today, your return will be 6.23% in one year. While as per the systematic risk(Beta) of the company the stock should provide a return of 8.78%. But since the stock is overpriced it will provide less return.

Thus, should not Invest in the company.