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Sample Essay

The stock price obtained from IBM website is 106.06 (IBM, 2009). The theoretical price is calculated using the CAPM and CGM models on the basis of risk free rate derived from the 10 year U.S treasury bonds. This basis affects the estimated theoretical price of the stock in a substantial way. The calculated theoretical price of the share is $11.33 which is significantly lower than the current price.

This huge difference in price is due to the estimated risk free rate and the market risk premium in CAPM. If we change interest rates slightly the required rate of return of IBM changes which in turn changes the theoretical price of the stock. If we lower the market risk premium and risk free rate just by 1 or 2 percentage points the theoretical value would jump to a very higher level.

Calculation of stock price with a market risk premium of 10%


Ks = KRF + (RPM) bi

Ks = 0.0354 + (0.1) (1.64)

Ks = 0.0354 + 0.164

Ks = 0.1994 ≈ 19.94%


P0 = D1 / Ks – g

P0 = 0.8656 / 0.1994 – 0.082

P0 = 0.8656 / 0.1174

P0 = $7.37

The new price of the stock after an increase in the market risk premium is $7.37 which is lower than the price previously calculated with a market risk premium of 7.5%. As explained in the answer to the previous question the stock price depends very much on the risk free rate and market risk premium. An increase in any of these rates would lower the price of the stock and a decrease in the rates would yield a higher stock price.

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