Unit 3 IP - Financial Management

Unit 3 IP Financial Management

Introduction

Companies require valuing their stock in order to know the current price of the security. The process of estimating fair value of the stock is termed as stock valuation i.e. valuing stock considering the several economic indicators which directly impact on the stock price. There are various methods through which stock price can be determined but in this unit CAPM (Capital Asset Pricing Model) and CGM (Constant Growth Model) will be used for determining stock price of XYZ Company.

The main concerns for these methods are to forecast the future market rice of the stock, in general potential market prices and to earn profit when price movement take place in the open market. Stocks are either undervalued or overvalued from the theoretical stock price i.e. overpriced stock are sold in the market and underpriced stock are brought for future gain and same criteria goes for selling and buying.

Discussion

From the data given in the excel sheet will be beneficial to calculate stock price through CAPM (Capital Asset Pricing Model) and CGM (Constant Growth Model).

Risk-Free Rate - Bloomberg.com

The Risk-Free Rate has been taken from the Bloomberg.com site which is the financial market news are available. U.S. 10-year Treasury rate of return is on this site is 1.1.95% whereas market risk premium value is 9%.

Stock information for XYZ Company

Stock information for XYZ Company has been taken from the data available

Beta of XYZ (B): 1.64

Current Annual Dividend XYZ: $0.8

3 year dividend growth rate of XYZ: 8.2%

P/E of Industry: 23.2

EPS of XYZ: $4.87

Required Rate of Return - Ks through CAPM

Requires rate of return from XYZ Company through CAPM model, we will be using the following formula:

Ks = KRF + (KRF - KRM)* (

Where:

RF = Risk free rate

RM = Market interest rate

ß = Company's Beta

(RF - RM) = Market Risk Premium

KRF = 1.95%

KRM = 9%

( = 1.64

Ks =1.95% + (9%) x 1.64

Ks = 16.71%

Require Rate of Return through CAPM has been 16.71% which means that minimum profit that will be earned through investment will be 16.71%.

Constant Growth Model - Stock price of XYZ

Under constant growth model following formula is used to determine the current stock

P0 = D1 / Ks - g

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

(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

Putting values in the formula

P0 = D1 / Ks - g

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

P0 = $10.1715

Comparison of P0 and P

Before we compare the XPZ company Stock price, it is essential to know that factors that affect the prices of stock in the market. The reason for stock price to change is due to the change in its multiples. This entails that stock-traders transform their analysis regarding the worth of the stock with no or any fundamental changes in the shares in achieving earnings or ...