Risk and Capital

Risk and Capital

This assignment aims to determine how stock prices are calculated and how market forces such as risk and interest rates affect these prices IBM 's financial information will be used as a model for this assignment The given data are listed below which are to be used in the calculations . The sources from which these data were obtained , and when they were obtained , are also listed as these data may differ from time to time

Data to be used for computation

risk-free rate of interest , krf 4 .85

(US 10-year Treasury http /www .bloomberg .com /markets /index .html , obtained on 5 Apr 2006

market risk premium 7 .5 (given in the assignment instructions

IBM 's beta 1 .64 (from - see attachment

IBM 's current annual dividend 0 .80 (from - see attachment

IBM 's 3-year dividend growth rate (g 8 .2 (from - see attachment

Industry

/E 23 .20 (from - see attachment

IBM 's EPS 4 .87 (from - see attachment

IBM 's Required Rate of Return , Ks , using CAPM

The required rate of return can be estimated using the formula

Ks Risk-free rate (Market Risk Premium (Beta

Using the above formula and the data above

Ks 4 .85 (7 .5 (1 .64 0 .0485 (0 .075 (1 .64 0 .1715 17 .15

IBM 's current stock price (theoretical stock price , Po

Using the constant growth model or Gordon model , the stock price can be determined using the formula where , d current annual dividend

r required rate of return

g constant dividend growth rate Therefore , the theoretical stock price , Po , is 9 .67

Compare current stock price with Po

From the website http /www .bloomberg .com /apps /quote ?ticker IBM :US , IBM stock price closed at 83 .45 on April 4 , 2006 . Comparing the current actual stock value and the theoretical value , we can find a huge difference between the two . This means that IBM is overvalued . However it is not necessarily true as IBM is a big name in the market . IBM is known worldwide and has a huge client base all over the world . Because of its name and reputation , customers would be willing to pay a premium price for IBM 's products . These factors , such as the company name products , market value , industry reputation , determine the actual price per share of the company

Also , it is difficult to predict that the growth rate of the company would be stable for a period of 3 years , 5 years , and so on . Growth rate fluctuates depending on the condition of the market and economy . This is one factor that could possibly explain why the theoretical value underestimates the intrinsic value of the equity

Change in market risk premium

If the market risk premium changes from 7 .5 to 10 with other factors remaining the same values , we 'll get the following

Ks Risk-free rate (Market Risk Premium (Beta

Ks 4 .85 (10 (1 .64 0 .0485 (0 .1 (1 .64 0 .2125 21...