Assignment Data: Risk free rate of interest rate on 10 year US Treasury bond: = 3.40% Beta of the Stock (IBM) = 1.64 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…
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. ...
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