The next questions refer to the following.
Suppose a stock exhibits no dividend growth; the current dividend is $21, and the required rate of return is 7%. The share price is currently $360.
-Suppose there is a 20% chance of mean reversion. Then if the bubble persists during the current period,the price will

Question

Quizplus · Accepted Answer

If there is no mean reversion, the stock price should be equal to the present value of all future dividends, which is dividend divided by the required rate of return. In this case, the stock price should be $300 (=$21/0.07). However, the actual stock price is higher at $360, implying that there is a bubble. If mean reversion occurs, the stock price will drop back to $300 (i.e. the fundamental value) with a 20% chance. Therefore, the expected (mean) return is 0.8(-6.67%)+0.2(20%)=1.63%. This implies that the stock price will rise by the expected return, which is 5.63% (=$360×1.0163−$360). Thus, the correct answer is (B).

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