Cookie Baking expects to pay $2.40 dividend next year ( D ₁ = 2.40)and the dividend is expected to grow at 4 percent annually. Cookie has an estimated standard deviation of .24, the market portfolio has a standard deviation of .12, the market expected return is .13 and the risk-free rate is .05. The correlation between Cookie and market returns is 0.8. What are Cookie's beta and required rate of return? A)1.16, 0.116 B)0.178, 1.6 C)1.6, 0.178 D)0.16, 2.60

Question

Quizplus · Accepted Answer

Step 1: Calculate the expected return on Cookie's stock using the dividend growth model:
    
    D1 = D0 x (1 + g)
    
    D1 = $2.40 x (1 + 0.04) = $2.496
    
    r1 = (D1 / P0) + g
    
    P0 = D1 / (r1 - g)
    
    r1 = (D1 / P0) + g = ($2.496 / P0) + 0.04
    
Step 2: Calculate the beta of Cookie's stock:

βcookie = ρcookie,mkt x (σcookie / σmkt)
    
    βcookie = 0.8 x (0.24 / 0.12) = 1.6

Step 3: Calculate the required rate of return using the CAPM:
    
    rcookie = rf + βcookie x (rmkt - rf)
    
    rcookie = 0.05 + 1.6 x (0.13 - 0.05) = 0.178 or 17.8%

Therefore, the correct answer is C) 1.6, 0.178.

Cookie Baking Expects to Pay $2