The next expected dividend for Stock P is $2.5, and the current price of the stock is $32.5. Its earnings, dividends, and price can be expected to grow at a constant rate of 4 percent per year. The risk free rate is 3%, the market risk premium is 5.5%, and the stock's beta is 1.2. Based on the given information, which of the following statements is correct?
A) An investor should buy this stock because its expected rate of return is 11.69%, and its required rate of return is 9.6%
B) An investor should not buy this stock because its expected rate of return is 9.6%, and its required rate of return is 11.69%
C) An investor should buy this stock because its expected rate of return is 12.54%, and its required rate of return is 8.28%,
D) An investor should not buy this stock because its expected rate of return is only 8.28%, and its required rate of return is 12.54%
E) An investor should be indifferent toward buying or selling the stock, because its required rate of return is equal to its expected rate of return.

Question

Quizplus · Accepted Answer

First, we can use the constant growth formula to calculate the expected dividend yield:
Expected Dividend Yield = (Expected Dividend / Current Price) + Expected Growth Rate
Expected Dividend Yield = ($2.5 / $32.5) + 0.04 = 0.1169 or 11.69%

Next, we can use the CAPM formula to calculate the required rate of return:
Required Rate of Return = Risk-Free Rate + Beta * Market Risk Premium
Required Rate of Return = 0.03 + 1.2 * 0.055 = 0.096 or 9.6%

Since the expected rate of return (11.69%) is greater than the required rate of return (9.6%), an investor should buy this stock.

The Next Expected Dividend for Stock P Is $2