Textbook Problem

RATES OF RETURN AND EQUILIBRIUM Stock C’s beta coefficient is b_C = 0.4, and Stock D’s is b_D = −0.5. (Stock D’s beta is negative, indicating that its return rises when returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.)

1. a. If the risk-free rate is 7% and the required rate of return on an average stock is 11%, what are the required rates of return on Stocks C and D?
2. b. For Stock C, suppose the current price, P₀, is $25.00; the next expected dividend, D₁ is $1.50; and the stock’s expected constant growth rate is 4%. Is the stock in equilibrium? Explain and describe what will happen if the stock is not in equilibrium.