The Abacus Computer Computer has decided to use the Capital

The Abacus Computer Computer has decided to use the Capital Asset Pricing Model (CAPM) to estimate its risk-adjusted rate of return (k) in order to determine the price of its common stock. The firm\'s beta is 1.5. The S&P; 500 has returned 10% to investors over a long period of time, and Abacus has decided to use this value as its expected market return. Treasury bills are currently providing investors with a risk-free return of 1%. Abacus next expected dividend is $3.25, and its growth rate of dividends is estimated at 10%, what is its nsk-adjusted rate of return and its stock price? Select one: 14.5% and $72.22 14.75% and $40.45 14.85% and $45.95 17.5% and $43.33

Solution

Correct option is > a. 14.5% and $72.22

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Using CAPM equation to solve for risk adjusted expected return:

Risk adjusted rate of return = Risk free rate + Beta x (Market return S&P - Risk free rate)

Risk adjusted rate of return = 1% + 1.5 x (10% - 1%)

Risk adjusted rate of return = 14.50%

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Now, we can calculate for stock price:

Stock price = Expected dividend / (Risk adjusted rate of return – Growth rate)

Stock price = 3.25 / (14.5% - 10%)

Stock price = $72.22