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EQUILIBRIUM STOCK PRICE The risk-free rate of return, r RF , is 6%; the required rate of return on the market, r M , is 10%; and Upton Company’s stock has a beta coefficient of 1.5. a. If the dividend expected during the coming year, D 1 , is $2.25 and if g a constant 5%, at what price should Upton’s stock sell? b. Now suppose the Federal Reserve Board increases the money supply, causing the risk-free rate to drop to 5% and r M to fall to 9%. What would happen to Upton’s price? c. In addition to the change in part b, suppose investors’ risk aversion declines and this, combined with the decline in r RF , causes r M to fall to 8%. Now what is Upton’s price? d. Suppose Upton has a change in management. The new group institutes policies that increase the expected constant growth rate from 5% to 6%. Also, the new management smoothes out fluctuations in sales and profits, causing beta to decline from 1.5 to 1.3. Assume that r RF and r M are equal to the values in part c. After all these changes, what is its new equilibrium price? ( Note: D 1 is now $2.27.)

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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250
BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250

Solutions

Chapter
Section
Chapter 9.A, Problem 2P
Textbook Problem

EQUILIBRIUM STOCK PRICE The risk-free rate of return, rRF, is 6%; the required rate of return on the market, rM, is 10%; and Upton Company’s stock has a beta coefficient of 1.5.

  1. a. If the dividend expected during the coming year, D1, is $2.25 and if g a constant 5%, at what price should Upton’s stock sell?
  2. b. Now suppose the Federal Reserve Board increases the money supply, causing the risk-free rate to drop to 5% and rM to fall to 9%. What would happen to Upton’s price?
  3. c. In addition to the change in part b, suppose investors’ risk aversion declines and this, combined with the decline in rRF, causes rM to fall to 8%. Now what is Upton’s price?
  4. d. Suppose Upton has a change in management. The new group institutes policies that increase the expected constant growth rate from 5% to 6%. Also, the new management smoothes out fluctuations in sales and profits, causing beta to decline from 1.5 to 1.3. Assume that rRF and rM are equal to the values in part c. After all these changes, what is its new equilibrium price? (Note: D1 is now $2.27.)

Expert Solution

a.

Summary Introduction

To compute: The selling price of Company U’s stock.

Introduction:

Stock:

Stock is an asset for the investors and a liability for the company. A stock is a kind of investment made by the investors, who want to get more returns. An investor holds the ownership right after the purchase of a stock of the respective company.

Explanation of Solution

Given information:

Beta coefficient is 1.5.

Risk free rate of return is 6%.

Market return is 10%.

Expected dividend is $2.25.

Growth rate is 5%.

Required rate of return is 12%.

Formula to calculate sale price is,

Price per share=Expected dividend(Required rate of returnGrowth rate)

Substitute $2.25 for expected dividend, 12% for required rate of return and 5% for growth rate.

Price per share=$2.25(0.120.05)=$2.250.07=$32.14

Working note:

Calculate the required rate of return

Expert Solution

b.

Summary Introduction

To compute: The sale price of Company U’s stock, when the risk free rate of return and market return falls.

Expert Solution

c.

Summary Introduction

To compute: The sale price of Company U’s stock, when the investor risk decline.

Expert Solution

d.

Summary Introduction

To compute: The equilibrium price of Company U’s stock.

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Chapter 9 Solutions

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