a. You expect that company A will pay its first dividend of $2 per share 3 years from today. After that the dividend is expected to grow at an annual rate of 5% for ever. The risk free rate is 6%, and the expected rate of return on the market is 10%. Also, the covariance between stock A and the market is 0.10, and standard deviation of the market portfolio is 20%. What is the fair value of the stock today?
b. Assume that the actual price is less than what you have calculated in part a. What does this say about its actual return compared to what is predicted by the security market line?
c. If it is true that properly priced securities fall on the security market line, what would you expect to happen to the price of stock A given that it is currently less than your calculation from part a? Explain why you believe that a price change would occur.