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Cost of Capital Preference Dividend

Cost of Capital Preference Dividend

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Published by ClassOf1.com
"Suppose the rate of return on short-term government securities (perceived to be risk-free) is 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the CAPM:
a) What is the expected rate of return on the market portfolio?
b) What would be the expected rate of return on a stock with β = 0?
c) Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 in
dividends next year and you expect to sell it then for $41. The stock risk has been evaluated
at β = −0.5. Is the stock overpriced or underpriced?
"
"Suppose the rate of return on short-term government securities (perceived to be risk-free) is 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the CAPM:
a) What is the expected rate of return on the market portfolio?
b) What would be the expected rate of return on a stock with β = 0?
c) Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 in
dividends next year and you expect to sell it then for $41. The stock risk has been evaluated
at β = −0.5. Is the stock overpriced or underpriced?
"

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Published by: ClassOf1.com on Feb 01, 2013
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Finance
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Sub: Finance Topic: Cost of Capital
*
The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
www.classof1.com/homework-help/finance 
Question:Cost of Capital Preference Dividend
Suppose the rate of return on short-term government securities (perceived to be risk-free) is 5%.Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is12%. According to the CAPM:
a)
 
What is the expected rate of return on the market portfolio?
b)
 
What would be the expected rate of return on a stock with β = 0?
 
c)
 
Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 in dividendsnext year and you expect to sell it then for $41. The stock risk has been evaluated
at β = −0
.5. Isthe stock overpriced or underpriced?
 
 
Sub: Finance Topic: Cost of Capital
*
The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
www.classof1.com/homework-help/finance 
Solution:
 
a.
 
As per CAPM,E[R
β=1
] = R
 
+ β(E[R
m
] − R
)E[R
β=1
] = 5% + 1(12% − 5%)
 
E[R
β=1
] = 12%
(Equal to market return, as market beta is equal to 1)b.
 
As per CAPM,E[R
β=
0
] = R
 
+ β(E[R
m
] − R
)E[R
β=
0
] = 5% + 0
(12% − 5%)
 
E[R
β=
0
] = 5%
(Equal to risk free return, as market beta is equal to 0)c.
 
E[R
β=−0.5
] = R
 
+ β(E[R
m
] − R
)
= 5% − 0.5(12% − 5%)
= 1.5% says the CAPMP
0
=E[P
1
] + E[D
1
] / 1 + R= (41 + 3) / (1 + 0.015)
= $43.35So the stock is underpriced according to the CAPM

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