Financial Management



Unit 3 IP Financial Management

Introduction

It is very essential for investors to evaluate the stock price before making an investment decision as share prices fluctuate on daily basis. According to the finance theory, stock prices inform investors about two things that are demand and supply as supply indicates the numbers of shares that are outstanding and demand indicates shares people desire to purchase and sell at that time.

In order to evaluate the stock price, investors need to know about the earnings of the company, Price/Earnings ratio of the company lastingly the PEG. In this unit, share price will be evaluate using two basic techniques that are CAPM - Capital Asset Pricing Model- and the constant growth model -CGM in order to arrive at XYZ's stock price.

Discussion

Risk-Free Rate of Interest

According to the Bloomberg.com, the “U.S. 10-year Treasury” rate of return is 1.95% while the value for the market risk premium is 9%.

XYZ Stock information

Data

XYZ's beta (ß)

1.64

XYZ's Current Annual Dividend

$0.80

XYZ's 3-year Dividend Growth Rate (g)

8.2%

Industry P/E

23.2

XYZ's EPS

$4.87

With the above information, XYZ's required rate of return - ks can be calculated. The formula to calculate ks CAPM formula will be used:

CAPM = RF + ß x (RM - RF)

Where:

RF = Risk free rate

RM = Market interest rate

ß = Company's Beta

(RF - RM) = Market Risk Premium

Putting the values in formula:

Ks = RF + ß x (RM - RF)

Ks = 1.95% + 1.64 x (9%)

Ks = 16.71%

Constant Growth Model - Stock price of XYZ

The formula for Constant Growth Model is as followed and this formula will be used for calculating price of stock:

Where D1 = (D0) * (1 + g)

The data is as followed:

(D0): Current Annual Dividend = $0.8

(g): Growth Rate = 8.2%

(Ks): Required Rate of return = 16.71%

(D1): Expected stock dividend = $0.8 * 1.082 = $ 0.8656

P0 = $ 0.8656 / (16.71% - 8.2%)

P0 = $10.1715

Compare Po and P - through web resources

The Current Stock Price of XYZ is $76.28 while the P0 is $10.175. There is a huge difference between the current stock price and initial price of the stock. The difference is of $ 65.705 i.e. (76.28-10.1715)/10.1715 which makes 650% increase from the initial year. The reason for this increase might be due to the many reasons but the main reason is the demand and supply for the stock in the open market. As we have state in the beginning that investors should be aware of the three things Earnings of the company, Price/Earnings ratio of the company lastingly the PEG. These things are the based on the demand and supply (Besley, Brigham, 2011).

Company earnings have huge impact on the stock prices. As company generate and make money, the confidence of the investors' increases and hence result in demand for the stock which ultimately increases the stock prices. Earnings of the company are also influence by the product and service quality, decision whether to invest in new product, expansion or target new segments. The earning of the company is ...