By walking through a set of financial data for XYZ, this assignment will help you better understand how

theoretical stock prices are calculated and how prices may react to market forces such as risk and interest rates. You will use both the CAPM (capital asset pricing model) and the constant growth model (CGM) to arrive at XYZ's stock price. To receive full credit on this assignment, please show all work, including formulae and calculations used to arrive at financial values. Assignment Guidelines: Find an estimate of the risk-free rate of interest (krf). To obtain this value, go to Bloomberg.com: Market Data and use the "U.S. 10-year Treasury" bond rate (middle column) as the risk-free rate. In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 7.5%. 2.625% Download the XYZ Stock Information by clicking the link. Using the information from the XYZ Stock Information document, record the following values: ?XYZ's beta () ?XYZ's current annual dividend ?XYZ's 3-year dividend growth rate (g) ?Industry P/E ?XYZ's EPS

1. 2. 3. 4. 5.

XYZ's beta () = 1.64 XYZ's current annual dividend = $0.8 XYZ's 3-year dividend growth rate (g) = 8.2% Industry P/E = 23.2 XYZ's EPS. = $4.87

With the information you recorded, use the CAPM to calculate XYZ's required rate of return (ks).

Under CAPM: Ks = KRF + (market Risk Premium) Ks =2.625 + 1.64(7.5) = 14.93%

Use the CGM to find the current stock price for XYZ. We will call this the theoretical price (Po).

Under CGM, we use the following formula for calculating the current stock price: P0 = D1 ks g

Since Current Annual Dividend (D0) = $0.8, and the Growth Rate is 8.2%, then expected stock dividend (D1) = $0.8*1.082 = $0.8656

P0 =

$0.8656 0.1493 0.082

= $12.87 Now use appropriate Web resources to find XYZ's current stock quote (P). Compare Po and P and answer the following questions: ?Are there any differences? ?What factors may be at work for such a difference in the two prices? The current stock price is $76.28, which means that there is a difference of $63.41 between the stock price calculated in 4 above and the current stock price (January 23) Such a difference could be due to the following: A) In calculating the rate of return we have assumed a market risk premium (which is the difference between the market required rate of return and the risk free rate of return) of 7.5%, such an assumption is not accurate since the market risk premium changes on daily basis, and as it does, it would affect XYZs required rate of return, which in turn would affect the calculated stock price. B) The growth rate used in the calculations is 8.2% while the current XYZ growth rate could be more than this rate, such a difference in the growth rate would result in a different price per share. C) The XYZ price per share had been increasing in the past month, this increase in the share price might have lead impulsive and inexperienced investors to

buy heavily into XYZ stock which might have been a factor in increasing the share price.

Now assume the market risk premium has increased from 7.5% to 10% and this increase is due only to the increased risk in the market. In other words, assume the krf and the stock's beta remain the same for this exercise. ?What will the new price be? Explain. Ks = 2.625 + 1.64(10) = 21.025% p0 = $0.8656 0.19025 0.082

P0 = $8.00 Since the increase in the risk premium implies an increase in risk, investors would expect a higher return on their investment to compensate for this increase in risk, such an increase in the rate of return would lead to a decrease in the share price.

Recalculate XYZ's stock price using the P/E ratio model and the needed info found in the XYZ Stock Information file. ?Why is the present stock price different from the price arrived at using CGM (Constant Growth Model)? XYZ EPS = $4.87 Industry P/E Ratio = 23.2 Stock price = (EPS)(P/E Ratio) = $4.87*23.2 = $112.98. The Price Earnings Ratio model is based on future expectations, the PE ratio reflects investors expectations about the company, its growth potential, as well as expectations about future dividends. From that we can see that the PE ratio model is based on future expectations while the Constant Growth Model is based upon past performance, such a difference between the two models is sure to result in a difference in the calculated price per share. If you used Microsoft Word to arrive at your answers, then you must provide an explanation of the formulas and calculations.