Confusion Corp 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 Confusion Corp shares to be $22 a year from now. The beta of Confusion Corp's stock is 1.25. What is the intrinsic value of Confusion's stock today?
A) $20.60
B) $20.00
C) $12.12
D) $22.00

Question

Quizplus · Accepted Answer

The intrinsic value of Confusion Corp's stock today can be calculated using the dividend discount model (DDM) with the Capital Asset Pricing Model (CAPM) to determine the required rate of return. CAPM formula: Required Rate of Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 4% + 1.25 * (14% - 4%) = 4% + 12.5% = 16.5%. Then, using the DDM formula: Price = Dividend / (Required Rate of Return - Growth Rate), assuming the growth rate is 0 because it's not provided, we get Price = $2 / (16.5%) = $12.12. However, this intrinsic value does not account for the expected price of the stock a year from now. The correct approach to include the expected price is to use the formula that accounts for the expected dividend and the expected price: Intrinsic Value = (Expected Dividend + Expected Price) / (1 + Required Rate of Return) = ($2 + $22) / (1 + 16.5%) = $24 / 1.165 ≈ $20.60.

Confusion Corp Is Expected to Pay a Dividend of $2