A stock has a beta of 0.27 and the risk-free rate is 6.15%. Its dividend growth rate is 4.11% and its P/E ratio is 8.9. If the firm has a dividend payout ratio of 23%, the market risk premium equals ________.
Click on the arrows to vote for the correct answer
A. B. C. D.Explanation
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) = 0.0411 + 0.23/8.9 = 6.69%. Now, CAPM implies that the expected return on a stock equals the risk-free rate plus beta times the market premium. Hence, 6.69% = 6.15% + 0.27 * market premium, giving market premium = (6.69% -
6.15%)/0.27 = 2.00%.