Financail Management - Risk and Capital - Essay Example

Assignment Data: Risk free rate of interest rate on 10 year US Treasury bond: = 3.40% Beta of the Stock (IBM 64 Market Risk Premium = 7.5% Current Annual Dividend = 0.80 3 Year Annual Dividend Rate = 8.2% Industry P/E = 23.2 Earnings per Share = $ 4.87 Calculation of Required rate of return: According to the Capital Asset Pricing Model Required rate of return = 3.40 + 1.64(7.5) Required Rate of Return = k = 15.7% Constant Growth Model D1= D0 (1+g) D1= 0.80 (1+0.082) = 0.8656 The market price of the stock is $ 128 which is far more greater than the price estimated from the Gordon Dividend Model.

There are several reasons for that, firstly the company that has been chosen is from High-tech industry where the sales are volatile and only few companies survive in the long term. We might have used a very low Dividend per share which might not be a actual resemblance to the dividend that it will be paying in the long term. Secondly we might have underestimated the growth rate which has a dramatic impact on the price of the stock. The higher the growth rate, the greater the price of the stock will be and it is expected that in the high-tech industry, a company such as IBM holds great expectation and it must have a better growth rate than what we have expected.

Therefore by increasing the dividend growth rate and current annual dividend we can get a better estimate from this model. This model underestimates the value of the stock in firms that consistently payout less than they can afford and accumulate cash in process. Changed Market Risk Premium: Required rate of return = 3.40 + 1.64(10) Required Rate of Return = k = 19.8% Constant Growth Model D1= D0 (1+g) D1= 0.80 (1+0.082) = 0.8656 As we have increased the required rate of return, we are assuming a greater risk with the stock which in turn decreases the value of the stock as it can be seen from the above calculations.

This also differs drastically from the market price due to the reason mentioned above. Industry P/E Stock Price = Industry P/E x EPS Price = 23.2 x 4.37 Price = $101.38 Using the industry P/E ratio, we believe that the stock is overvalued either because the investors hold great expectations out of the company as it is the market leader or it is in the growth stage or either the current EPS is not realistic of what it should be in the current period. References: Bloomberg (2010), Available: http://www.bloomberg.com/markets/