A share of stock with a beta of 0.75 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4%, and the market risk premium is 7%. a. Suppose investors believe the stock will sell for $52 at year-end. Calculate the opportunity cost of capital. Is the stock a good or bad buy? What will investors do?
What the investors will do depends on whether the actual return will be higher, lower or the same as the required return (Opportunity cost of capital) .
The Actual return can be calculated using the Holding Period Return which is;
= (Earnings(Dividends) + (Ending Stock Price - Beginning Stock Price))/Beginning Stock Price
= (2 + (52 - 50))/50
The Opportunity Cost of Capital can be calculated using CAPM.
= Risk Free Rate + beta(Market Premium)
= 4% + 0.75(7%)
The Opportunity Cost of Capital is greater than the Actual Return from the stock so the stock is a bad buy.
Investors will not invest.