Monica Dubois, an ABC investment advisor, has a new client, Mr. Jack Klein. Mr. Klein is a conservative investor who is interested in a required rate of return of 10% on his stock investments while assuming lower market risk. You are asked to help Monica make a suitable portfolio recommendation backed by risk-return calculations. The 3 possible stock choices for Mr. Klein and their respective betas are as follows:
| Stock | Expected Return | Beta |
| ABC | 10% | 0.75 |
| XYZ | 11% | 1.0 |
| WHY | 12% | 1.25 |
Part I
Determine the expected returns and beta for a portfolio consisting of one third of Mr. Klein’s funds in each stock.
Part II
Assume the following:
- Each ABC stock pays current dividends of $1.50 annually with 6% expected annual increases. The current market stock price for ABC is $30 per share.
- Each XYZ stock pays current dividends of $1.75 annually with 6% expected annual increases. The current market stock price for XYZ is $27 per share.
- Each WHY stock pays current dividends of $2.25 annually with 7% expected annual increases. Current market stock price for WHY is $35 per share.
Complete the following for this assignment:
- Using the constant dividend growth model, determine whether ABC and WHY are over- or undervalued.
- For what types of companies is the constant growth model an appropriate analysis tool?
- What are the limitations of the constant growth model?
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