The risk-free rate of return is 2.5 percent; the expected rate of return on the market is 7 percent. Stock X has a beta coefficient of 1.3, an earnings and dividend growth rate of 4 percent, and a current dividend of $1.40. If the stock is selling for $35, what should you do based on CAPM and CDGM

Stock is overpriced/ overvalued. Sell if you own it. Don't buy if you don't.

Explanation:

Use CAPM to find the required return on the stock:

Required return = Risk free rate + beta * ( Market return - risk free rate)

= 2.5% + 1.3 * (7% - 2.5%)

= 8.35%

Price based on Constant Dividend Growth Model (CDGM):

Price = Next dividend / (Required return - growth rate)

Next dividend = 1.40 * ( 1 + 4%)

= $1.456

Price = 1.456 / (8.35% - 4%)

= $33.47

Stock is selling for $35. It is overvalued. Don't buy the stock. Sell if you have the stock.

1. Classifying each cost as Variable or Fixed

When total cost changes with change in output then it is variable in nature and when it remains constant then it is fixed cost.

Plastic for casing = (a) Variable cost (b) Product as will depend on number of casing. = $21,000 / 1000 units = $21 per casing if casing is per unit done individually.Wages of assembly workers = (a) Variable Costs (b) Period it will depend on number of hours worked, in piece rate system it will depend on number of units, but generally it is based on number of hours so it is period.Property taxes on factory = (a) Fixed Costs (b) Period as this does not depend on number of units produced it is fixed in nature, with time duration.Accounting staff salaries = (a) Fixed Costs (b) Period as this is not related to number of units produced and will be fixed for a month.Drum Stands = (a) Variable cost (b)Product as will be required for each drum individually manufactured.Rent cost of equipment for sales staff = (a) Fixed Cost (b) Period as rented is fixed  for a specified period generally paid monthly and is not based on number of units produced.Upper management salaries = (a) Fixed Cost (b) Period as this is fixed annually and not based on number of units produced.Annual flat fee for factory maintenance service = (a) Fixed Cost (b) Period as this is fixed annually and has no relation with number of units produced.Sales commissions = (a) Variable Costs (b) Product as this is based on number of units sold and defined per unit.Machinery depreciation, straight-line = (a) Fixed Cost (b) Period as this is not based on number of units produced and is fixed annually.