A stock has a beta of 1.44 and the market risk premium is 7.4%. Its dividend growth rate is 5% and its P/E ratio is 4.2. If the firm has a dividend payout ratio of
45%, the risk-free rate equals ________.
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A. B. C. D.A
If the expected return on the stock is K, then the Dividend Discount Model gives
P/E = (dividend payout ratio)/(K - g). Therefore, K = g + (div. payout ratio)/(P/E) = 0.05 + 0.45/4.2 = 15.71%. Now, CAPM implies that the expected return on a stock equals the risk-free rate plus beta times the market premium. Hence, 15.71% = Rf + 1.44 * 7.4%, giving Rf = 5.06%.