Question: Consider an economy where CAPM holds, and where the risk-free rate is Rf = 2%, the expected return on the market portfolio is ERm = 12%, and the standard deviation of the return on the market portfolio is sm = 30%. The covariance between the return of ABC stock and the return of the market portfolio is equal to 0.18. All of this data refers to annual returns.
(a) What is the expected (annual) return of ABC stock?
(b) If ABC's dividends equal $10 per share next year and grow at a rate of 12% per year subsequently, what is the current price per share of ABC stock?
(c) Now suppose that the dividend growth of ABC depends on the success of a clinical trial for their product. If the trial is successful, dividend growth will be 17%. If the trial is unsuccessful, dividend growth will be 7%. The trial is successful with probability 50%. The success of the trial is uncorrelated with the return on the market portfolio (which is to say that the beta of ABC is the same as before). Next year's dividend will be $10 irrespective of the outcome of the trial. What should be the share price of ABC stock in this environment? Hint: compute the share price when G = 7% with certainty, and when G = 17% with certainty, then compute the expected price knowing the fact that both outcomes are equally likely.
(d) Compare your answers to (b) and (c). Which one is higher? Explain the intuition behind this result.
(e) Use the analysis in this example to evaluate the argument that technology companies had such high prices in the late 1990s partly because of uncertainty about the success of new technologies used by them. Based on the example, is this argument plausible?