A question by Eeyore J The current price of a share of stock in the Down Under Clothing Company of Australia is A$50 and its expected yield over the year is 0.14. The market risk premium in Australia is 0.08 and the riskless interest rate 0.06. What would happen to the stock’s current price if its expected future payout remains constant while the covariance of its rate of return with the market portfolio falls by 50%?Eeyore J
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The previous answer can be improved, as this question that’s not means D1 is constant. It means all dividends in the time horizon is constant, which symbols for P+D/1+r is the same after the change. So, it should be (1+r1)/(1+r2) =P1/P2, the new price would be 51.82.Yuan
use CAPM to find the required return, k. since the covar with the market (its Beta) falls by 50% it must be that Beta=0.5 (the Beta of the market=1.0) So k=Rf +(MRPBeta) k=0.06 + (0.080.5)=0.10 or 10% Then use the constant growth (Gordon) model to find the price P0=D1/(k-g) where P0=price today D1=dividend at end of the year which is $50*0.14=7.00 k=0.10 g=0 ( no growth as stated in the problem) P0= 7.00/ (0.10-0)= $70 The price should go to $70.Dani
updated 8 December 2022