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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

RATES OF RETURN AND EQUILIBRIUM Stock C’s beta coefficient is bC = 0.4, and Stock D’s is bD = −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.

a.

Summary Introduction

To compute: The required rate of return on Stock C and D.

Introduction:

Stock:

Stock is an asset for the investors and a liability for the company. A stock is a kind of investment made by the investors, who want to get more returns. An investor holds the ownership right after the purchase of a stock of the respective company.

Rate of return:

The rate of return is the amount that an investor receives by contributing the money on another asset. In simple words, return on asset is the amount received by investing the money.

Explanation

Given information:

Beta coefficient of stock C is 0.4.

Beta coefficient of stock D is 0.5 .

Risk free rate of return is 7%.

Market return is 11%.

Formula to calculate the required rate of return is,

rx=rRF+(rmrRF)bx (I)

Where,

  • rRF is the risk free rate of return.
  • rm is the market return.
  • bx is the beta coefficient.

Stock C

Substitute 7% for risk free rate of return, 11% for rate of return 0.4 for beta coefficient, in the equation (I).

rx=0.07+(0.110

b.

Summary Introduction

To describe: The stock is in equilibrium and when it is not in equilibrium.

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