RISK AND CAPITAL

Risk and Capital



Risk and Capital

Case- 1

Risk free rate of interest (krf) - U.S. 10 - year Treasury bond rate

2.58 %

Market risk premium

7.50 %

XYZ's beta (ß)

1.64

current annual dividend

$0.80

XYZ's 3 - year dividend growth rate (g)

9.20 %

Industry P / E ratio

15.65

XYZ's Earning per share

$ 4.87

CAPM (capital asset pricing model)

rj = rf + ß (rm - rf)

where:

Rj = expected return on asset j

Rf = ten year US Treasury rate (the risk free rate)

b = beta

rm = market return

rp = risk premium

CAPM or rj =

2.58%

+

( 1.64 * 7.50% )

As,

rp =

rm

- rf

CAPM or rj =

2.58%

+

( 1.64 * 7.50% )

CAPM or rj =

2.58 %

+

0.12

CAPM or rj =

10.08 %

Constant Growth model (CGM)

D1 =

Do

*

1

+

( - 0.092 )

D1 =

0.8

*

0.908

D1 =

0.7264

Po =

D1

Kj - g

 

$ 0.73

 

0.1008

-

- 0.092

Po =

$ 0.73

0.1928

Po =

$ 3.79

The current stock price is $ 76.28, which means that there is a difference of $ 80.07 between the stock prices calculated in the above method. Such a difference could be due to the following reasons that include the growth rate used in the calculations is -9.2 % while the current XYZ growth rate could be more than this rate, such a difference in the growth rate would result in a different price per share.

The per share price of XYZ had been increasing in the past, this increase in the share price might have lead impulsive and inexperienced investors to buy heavily into XYZ stock which might have been a factor in increasing the share price. In calculating the rate of return we have assumed a market risk premium (which is the difference between the market required rate of return and the risk-free rate of return) of 7.5 %, such an assumption is not accurate since the market risk ...