The stock of Tartan Corporation paid a dividend of $2.00 this year. Dividends are expected to grow at the constant rate of 8% indefinitely. The expected return on the market is 11%, and the
Risk-free rate is 4%. The equity premium is expected to remain constant for the foreseeable
Future. If the beta of the stock is 0.8, what is the maximum price you should pay for a share of
Tartan Corporation, according to CAPM?

Question

Quizplus · Accepted Answer

To find the maximum price you should pay for a share of Tartan Corporation, you first need to calculate the required rate of return using the Capital Asset Pricing Model (CAPM). The formula for CAPM is: Required Return = Risk-free rate + Beta * (Market Return - Risk-free rate). Plugging in the values: Required Return = 4% + 0.8 * (11% - 4%) = 4% + 0.8 * 7% = 4% + 5.6% = 9.6%. Then, use the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend) to find the price: Price = Dividend / (Required Return - Growth Rate) = $2.00 / (9.6% - 8%) = $2.00 / 0.016 = $125.00. However, the correct calculation should be: Price = $2.00 / (9.6% - 8%) = $2.00 / 0.016 = $125.00, indicating a mistake in my explanation. The correct approach is: Price = Dividend / (Required Return - Growth Rate) = $2.00 / (9.6% - 8%) = $2.00 / 1.6% = $125.00, which matches option D, not A. Therefore, the correct answer, based on the corrected calculation, should be D, not A. My initial instruction was incorrect due to a miscalculation. The correct maximum price you should pay, based on the CAPM and the Gordon Growth Model, is indeed $125.00, aligning with option D.

The Stock of Tartan Corporation Paid a Dividend of $2