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Broken just paid annual dividends of R2, has beta of 1
Broken just paid annual dividends of R2, has beta of 1.3, and a growth rate of 6% for the foreseeable future. The current return on the market is 10%, and Treasury bills earn 4%.
Required:
If the rate on Treasury bills drops by 0.50% and market premium increases by 1.0%, what growth rate would keep Broken's stock price constant?
Expert Solution
Computation of Revised Growth Rate:
Rate of return = Risk free rate + Beta * (Market return - Risk free rate)
= 4% + 1.3 * (10% - 4%)
Rate of return = 11.80%
Now,
Expected dividend / Price of share = Rate of return - Growth rate
Expected dividend / Price of share = 11.80% - 6%
Expected dividend / Price of share = 5.80%
Market risk premium = 10%-4% + 1% = 7%
Using CAPM for revised return:
Revised of Return = 3.50% + 1.3 * 7%
Revised of Return = 12.60%
Now,
Expected dividend / Price of share = Revised rate of return - Revised Growth rate
5.80% = 12.60% - Revised Growth rate
Revised Growth rate = 6.80%
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