Question - The company's common stock is going to pay a dividend is $2.00 per share after one year. Dividends are expected to grow at 10 percent per year for 2 years after that ($2.20 two years from now, and $2.42 3 years from now), and 4% thereafter.
The expected market return is 6%, your stock has a beta of 1.2. The return on riskless government bonds is 2%.
1. Assuming CAPM is correct, what should be the price of the stock?
2. Suppose the market price of the stock is $30 (different from the price that CAPM says it should be), what would the investors think about investing in the stock?
We need to look at this from the market perspective of what is a fair rate of return for the investment compared to alternatives available.