Aurum Inc. pays perpetual dividends of $2 per share (D1 = D2 = Dt = $2); next dividend is expected in one year (at t=1). Aurum’s current stock price is $25, it has an equity beta of 1.2, the market risk premium is 5%, and the risk-free rate is 3%. Which of the following statements is true:
a) The stock is undervalued, and plots above the security market line
b) The stock is overvalued, and plots above the security market line
c) The stock’s return is lower than what it should be based on its risk
d) The stock’s return is higher than what it should be based on its risk
e) Both A) and D)
2. Bikes-B-Rode has performed a risk assessment of independent projects. They adjust for project risk by raising the calculated IRR by 2% for low-risk projects, leaving the IRR the same for moderate risk projects, and lowering the calculated IRR by 3% for high-risk projects. Without capital rationing, and given their cost of capital of 10%, which projects should Bikes-B-Rode accept? Why?
Risk
Project Cost NPV IRR Level
A $16,000 $ -1,000 8% Low
B $28,000 $ 4,000 13% Low
C $34,000 $ 4,000 12% Average
D $42,000 $ 5,000 12% High