Answer to Question #157675 in Financial Math for Srinivas

Question

The firm is Costco Wholesale Corporation. Beta is 0.67. Please provide the following

a. A SML calculation for your firm’s stock, using this beta and 5 year averages of historical market (NYSE or S&P 500) returns and historical Treasury bill returns.

b. A comparison of the SML required return on your firm’s stock and the discounted stock valuation required return on the stock. {P0= D1/ (rs-g) implies rs = D1/P0 + g}.

Answer 1

a. Expected rate of return:

$E(R_{cost}) = R_F + β[E(R_M) – R_F]$

$R_F$ is rate of return on historical Treasury bill returns

$β$ is systematic risk

$E(R_M)$ is expected rate of return on market portfolio (5 year averages of historical market, S&P 500, 2017 - 2021)

$E(R_M)=\frac{19.42-6.24+28.88+16.26+2.58}{5}=12.18$ %

$E(R_{cost})=1.98+0.67(12.18-1.98)=8.81$ %

b. Rate of Return = (Dividend Payment / Stock Price) + Dividend Growth Rate

Dividend Payment$=2.75$ %

Stock Price$=9.02$ %

Dividend Growth Rate$=12.59$ %

Required Rate of Return$=2.75/9.02+12.59=12.89$ %

So, we have:

SML Rate of Return$<$ Discounted Stock Valuation Return