An issue of common stock currently sells for $50.00 per share,has an expected dividend to be paid at the end of the year of $2.50 per share,and has an expected growth rate to infinity of 5% per year.If investors' required rate of return for this particular security is 12% per year,then this security is
A)overvalued and offering an expected return higher than the required return.
B)undervalued and offering an expected return higher than the required return.
C)overvalued and offering an expected return lower than the required return.
D)undervalued and offering an expected return lower than the required return.

Question

Quizplus · Accepted Answer

To determine if the stock is overvalued or undervalued, we need to use the dividend discount model:

Expected return = (Expected dividend/Current stock price) + Expected growth rate

Expected return = (2.50/50) + 0.05 = 0.10 + 0.05 = 0.15 or 15%

Since the required rate of return for investors is 12%, the expected return of 15% is higher than the required return. This indicates that the stock is overvalued and offering an expected return lower than the required return. Therefore, the best choice is option C.

An Issue of Common Stock Currently Sells for $50