Case Scenario:
Sam and Sally Vallarta have a portfolio consisting of the following investments:
1. $20,000 of Speightstown Corp. common stock, consisting of 800 shares with a current market price of $25 per share. The Beta of Speightstown Corp. stock is 1.20, and the stock pays no dividends.
2. $15,000 of Lucca Corp. common stock, consisting of 150 shares with a current market price of $100 per share. The beta of Lucca stock is .60 and it paid annual dividends of $5.75 per share during the past year. Dividends are expected to grow at a rate of 4% per year.
3. 30 Frederickstad Corp. bonds (face value of $1,000 each) maturing in 2020. These bonds have a coupon of 5.2% and pay interest annually. They are rated AA by Standard and Poors.
Assume that these are all owned in joint tenancy, and not held in IRAs or other tax-deferred vehicles (like 401k's).
Instructions:
Problem 1. Using the Capital Asset Pricing Model (CAPM), determine the expected rate of return next year for investment #1. Assume a market premium of 7%.
Problem 2. Using the dividend growth model, determine the value of investment #2 if the Vallartas' required rate of return for this investment is 4.5%.
Problem 3. Determine the value of investment #3 if the Vallartas' required return for this investment is 5%.