CAPM ILLUSTRATION

Illustration 1 (CAPM)

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Investment in equity shares

Initial price

Dividend

Market price (end of the year)

Beta risk factor

Cement Ltd

25

2

50

0.8

Steel Ltd

35

2

60

0.7

Liquor Ltd

45

2

135

0.5

Government bonds

1000

140

1005

0.99

Risk-free rate may be 14%

You are required to calculate

a)      Expected return using Capital asset pricing model (CAPM)

b)      Average return of the portfolio.

 

Illustration 2

The following are facts available:

Risk-free rate 9%

Return of the market portfolio 18%

Beta coefficient of the shares of ABC Ltd. is 1.5

Dividend to be declared at the end of the year is  3 per share

Growth rate in dividend is 8 %.

Compute the price at which shares of ABC Ltd. should sell.

 

Illustration 3

The Beta coefficient of Target Ltd is 1.4. The company is maintaining 8% rate of growth rate in dividend and earnings. The last dividend was 4 per share. The return on Govt. securities is 10% while the return on the market portfolio is 15%. The current market price of one share of Target Ltd is  36.

(a)    What will be the equilibrium price per share of Target Ltd.

(b)   Would you advise in purchasing share.

 

Illustration 4

The following data pertain to the value of underlying factors of A Ltd.’s shares.

 

Value of Underlying Factors

 

Original

Revised

Risk-free rate

Market risk premium

Beta

Expected growth rate

Previous dividend

10%

5%

1.2

6%

2

8%

6%

1.5

8%

2

(a)   What is the intrinsic value of A Ltd.’s share based on the original set of values?

(b)   What will it be under the revised set of values?

 

 

Illustration 5 Case Study

Anand heads the portfolio management schemes division of Phoenix Investments, a well known financial services company. Anand has been requested by Arrow Technologies to give an investment seminar to its senior managers interested in investing in equities through the portfolio management schemes of Phoenix Investments. Manish, the contact person of Arrow Technologies, suggested that the thrust of the seminar should be on equity valuation. Anand has asked you to help him with his presentation.

 

To illustrate the equity valuation process, you have been asked to analyse Acme Pharmaceuticals which manufactures formulations and bulk drugs. In particular, you have to answer the following questions:

  1. What is the general formula for valuing any stock, irrespective of its dividend pattern?
  2. How is a constant growth stock valued?
  3. What is the required rate of return on the stock of Acme Pharmaceuticals? Assume that the risk-free rate is 7 percent, the market risk premium is 6 percent, and the stock of Acme has a beta of 1.2.
  4. Assume that Acme Pharmaceuticals is a constant growth company which paid a dividend of  5.00 yesterday (D0 =  5.00) and the dividend is expected to grow at the rate of 10 percent per year forever.
    1.                                 i.            What is the expected value of the stock a year from now?
    2.                               ii.            What is the expected dividend yield and capital gains yield in the first year?
  5. If the stock is currently selling for  110, what is the expected rate of return on the stock? Assume D0 =  5 and g = 10 percent.
  6. Assume that Acme Pharmaceuticals is expected to grow at a supernormal growth rate of 25 percent for the next 4 years, before returning to the constant growth rate of 10 percent. What will be the present value of the stock under these conditions? What is the expected dividend yield and capital gains yield in year 2? year 5? Hereafter assume D0 =  5.00 and a 15 percent required return.
  7. Assume that Acme Pharmaceuticals will have zero growth during the first 2 years and then resume its constant growth of 10 percent in the third year. What will be the present value of the stock under these conditions?
  8. Assume that the stock currently enjoys a supernormal growth rate of 30 percent. The growth rate, however, is expected to decline linearly over the next four years before settling down at 10 percent. What will be the present value of the stock under these conditions?
  9. Assume that the earnings and dividends of Acme Pharmaceuticals are expected to decline at a constant rate of 5 percent per year. What will be the present value of the stock? What will be the dividend yield and capital gains yield per year?
  10. Assume that the earnings and dividends of Acme Pharmaceuticals are expected to grow at a rate of 30 percent per year for the next 3 years and thereafter the growth rate is expected to decline linearly for the following four years before settling down at 10 percent per year forever. What will be the present value of the stock under these conditions?

 

 

For Solution/ Answer Please refer IAPM Textbook By Author Pawan Jhabak, Himalaya Publication.

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