For Mr. Klein, diversification is important in minimizing unsystematic risk than may arise as a result of buying the shares of one company. Buying one third of each stock should result in expected return higher or equal to 10%. The Expected Return will be as follows;
Company Cost of Capital Beta Expected Return Klein’s Return
ABC 10% 0.75 7.5/3 =2.5
XYZ 11% 1.0 11/3 =3.67
WHY 12% 1.25 15/3 =5.0
Expected Return from the three Stocks 11.17
The value of the Beta will be determined using Capital Asset Pricing Model (CAPM) as follows;
11.17%=10% +(11.17%-10%)Beta. This gives a result of Beta equal to 1.00.
To determine whether the shares of ABC and WHY are over or undervalued, the constant dividend growth model is used. This is given as; Po= D1/ Ke-g where Po is the Intrinsic Value, D1 is the expected dividend after applying the dividend growth rate (Do (1+g)). Ke is the expected return on equity and g is the growth rate.
For ABC, the intrinsic value will be 1.50(1+0.06)/(10%-6%). This gives a theoretical value of $39.75. Therefore the shares are undervalued as they are currently trading at $30. For the shares in WHY, they are trading at $35 in the market. Its real value should be $48.15. This is computed from the following; 2.25(1.07)/ (12%-7%).
In both cases, Monica should advice Mr. Klein to buy the shares now as they are undervalued in the market. This is because due to forces of demand and supply, the prices will be pushed up to their intrinsic values which will be $ 39.15 for ABC shares and$48.15 for WHY shares instead of $30 and $35 respectively.
Constant growth model is an appropriate analysis tool for companies that maintain a constant growth in dividends to its shareholders. This growth rate should not be more than the return on equity. This model is also suitable for companies that can determine their dividend pay-out right. The limitations of constant growth model include the following:
- The return on equity/cost of capital must be greater than the growth rate i.e. ke>g. Failure of this principle leads to absurd results (Pandey, 2006). This is because where they are equal; the result will be an infinite price. On the other hand, if Ke<g, the result will be a negative price.
- The initial dividend per share, D1, must be greater than zero. Failure of this will result in a zero share price.
- The relationship between cost of capital (Ke) and Growth rate(g) is assumed to remain constant and perpetual (Pandey, 2006).