Suppose that a stock at 115 and it has an expected dividend

Suppose that a stock at $115 and it has an expected dividend of $2.5 and an expected price of $121. 1 in one year. This stock has a beta of 1.4. The return on a 10-year T-bond is currently 2.6% and the expected return on the market it 7.75%. a. What is the stocks holding period return? b. What is stock\'s fair return according to CAPM?

Solution

Holding period return

Capital gain (CG) = Price in one year - Price now = $121.1 - $115 = $6.1

Expected Dividend (D) = $2.5

Holding period return = [ (CG + D) / Price now ] x 100 = [ ($6.1 + $2.5) / $115 ] x 100 = 7.478261% or 7.48%

Fair return

Return as per CAPM = Risk free rate + Beta x (Market return - Risk free rate)

or, Return as per CAPM = 2.6% + 1.4 x (7.75% - 2.6%) = 9.81%