An issue of ordinary shares 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

Question

Quizplus · Accepted Answer

We can use the constant growth model to calculate the estimated intrinsic value of the security:
Intrinsic Value = (Dividend / (Required Rate of Return - Growth Rate))
= ($2.50 / (0.12 - 0.05))
= $35.71

Since the current market price is $50, the security is overvalued. Additionally, the expected return of the security can be calculated using the following formula:
Expected Return = Dividend Yield + Capital Gains Yield
Dividend Yield = (Dividend / Current Market Price) = $2.50 / $50 = 0.05 or 5%
Capital Gains Yield = Expected Growth Rate = 0.05 or 5%
Expected Return = 0.05 + 0.05 = 0.10 or 10%

Since the required rate of return is 12%, the expected return of the security is lower than the required return, indicating that the security is overvalued and offering an expected return lower than the required return.

An Issue of Ordinary Shares Currently Sells for $50