Stock Market Equilibrium

by Maestri

Recall that ri, the required return on Stock i, can be found using the Security Market Line (SML) equation as it was developed in our discussion of the Capital Asset Pricing Model (CAPM) back in Chapter 3: If the risk-free rate of return is 8 percent, the required return on an average stock is 12 percent, and Stock i has a beta of 2, then the marginal investor will require a return of 16 percent on Stock i: This 16 percent required return is shown as the point on the SML in Figure 5-4 associated with beta 2.0.

The marginal investor will want to buy Stock i if its expected rate of return is more than 16 percent, will want to sell it if the expected rate of return is less than 16 percent, and will be indifferent, hence will hold but not buy or sell, if the expected rate of return is exactly 16 percent. Now suppose the investor’s portfolio contains Stock i, and he or she analyzes the stock’s prospects and concludes that its earnings, dividends, and price can be expected to grow at a constant rate of 5 percent per year. The last dividend was D0 $2.8571, so the next expected dividend isOur marginal investor observes that the present price of the stock, P0, is $30. Should he or she purchase more of Stock i, sell the stock, or maintain the present position?

Taken From : Five-Minute MBA – Corporate Finance

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