Question B2

Malik Khan is the chief security analyst at the JP Morgan investment firm. A client has requested him to conduct a stock valuation of Mitts Medical, a supplier of hospital equipment which is listed on the stock exchange. The client will be making investment decision based on the outcome of Maliks valuation.

Malik has gathered some information that is necessary for him to conduct the valuation. He estimated that the beta coefficient of Mitts Medical to be 1.5, the market rate of return to be around 10 percent while the risk-free rate, 2 percent. Last year, Mitts Medical issued a dividend of 50 pence per share. Malik believes that Mitts Medical is a constant growth company whose dividend is expected to grow indefinitely at 4 percent.

Required:

(a) What is the required rate of return of Mitts Medical? (3 marks)

(b) What is the current share price of Mitts Medical? (3 marks)

(c) What is the stocks expected value 1 year from now? (3 marks)

(d) What are the expected dividend yield, capital gains yield and total return during the first year? (5 marks)

(e) Now assume that Mitts Medical is expected to experience non-constant growth of 20 percent for the next 3 years, 10 percent for the subsequent 2 years and then return to its long-run constant growth rate of 4 percent. What is the stocks current value under these conditions? (8 marks)

(f) Now assume that the stock is selling at 80 pence. What is the expected rate of return? Using the answer obtained in part (a), illustrate the expected rate of return of Mitts Medical using a security market line diagram. What can you conclude about this stock? (8 marks)