- CFA Exams
- CFA Level I Exam
- Topic 5. Equity Investments
- Learning Module 41. Equity Valuation: Concepts and Basic Tools
- Subject 3. Present Value Models: The Dividend Discount Model

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**CFA Practice Question**

You observe a stock that has a risk of premium of 6.5% and is expected to pay a dividend of $1.50 into perpetuity. Treasury bills are expected to yield 5% over the same period of time. What amount is the most that you would pay for this stock?

A. $13.04

B. $15.62

C. $21.78

**Explanation:**P (0) = D(1)/(k-g)

In this case:

D(1) is $1.50, G = 0, since there is no growth in dividends, and K can be derived as follows:

we know that the risk premium or ( k- Rf) = 6.5%, we also know that Rf = 5%; therefore, subtracting Rf in the risk premium equation gives us: k - 5% = 6.5% => k = 11.5%.

Hence P = 1.5/11.5% = $13.04.

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**User Contributed Comments**
3

User |
Comment |
---|---|

ChrisCat |
I think this question is wrong ... if the equity risk premium is 6.5% which is Rm-RFR and the RFR is 5% then the market return is 1.5% which is K not 11.5%. Can someone explain? |

theresa |
@ChrisCat: it is correct. required return = equity risk premium + risk free rate = 6.5% + 5%. |

GBolt93 |
@ChrisCat: the equity premium is 6.5% not he market return. Rm=market return. E.G. Rm=Premium + Rf=6.5+5=11.5 |