Sure Tool Company is expected to pay a dividend of $2 in the upcoming year.The risk-free rate of return is 4%, and the expected return on the market portfolio is 14%.Analysts expect the price of Sure Tool Company shares to be $22 a year from now.The beta of Sure Tool Company's stock is 1.25. The market's required rate of return on Sure's stock is

Question

Quizplus · Accepted Answer

Using the dividend discount model:

- Sure Tool Company's expected dividend (D1) = $2
- Sure Tool Company's expected stock price a year from now (P1) = $22
- Sure Tool Company's current stock price (P0) = unknown

To find the current stock price, we can rearrange the dividend discount model to solve for P0:

P0 = (D1 / (1 + r)) + (P1 / (1 + r))

where:
r = required rate of return

We can use the capital asset pricing model (CAPM) to find the required rate of return:

r = Rf + beta x (Rm - Rf)

where:
Rf = risk-free rate of return = 4%
beta = stock's beta = 1.25
Rm = expected return on the market = 14%

Plugging in the values:

r = 0.04 + 1.25 x (0.14 - 0.04) = 0.04 + 1.25 x 0.1 = 0.04 + 0.125 = 0.165 = 16.5%

Now we can plug in the values for D1, P1, and r to find P0:

P0 = ($2 / (1 + 0.165)) + ($22 / (1 + 0.165)) = $1.7296 + $18.7278 = $20.4574

Therefore, the market's required rate of return on Sure Tool Company's stock is 16.5%.

Sure Tool Company Is Expected to Pay a Dividend of $2