As financial manager of Organics, Inc., you have recently concurred with a gener
ID: 2698176 • Letter: A
Question
As financial
manager of Organics, Inc., you have recently concurred with a
general management decision to enter into the plastics business.
Much to your surprise, the price of the firm’s
common stock subsequently declined from $40 per share to $30 per
share. You are anxious to determine how
the market perceives the relevant risk of the firm and you have
determined that the following changes in the financial markets have
occurred since Organics entered into the plastics business:
Â
"margin-left:1in;text-indent:-.25in;">(a)
"font:7pt 'Times New Roman';">Â Â
The real rate of interest has been constant at 2% but the inflation
premium has increased from 4% to 6%; (
"color:#00B0F0;">r
"color:rgb(0,176,240);">iskless rate is the real rate + inflation
(therefore it’s increased by 2%)
"margin-left:1in;text-indent:-.25in;">(b)
"font:7pt 'Times New Roman';">Â
The
expected growth rate has been re-evaluated and a 10.5% rate is now
considered to be more realistic than the previous 5% rate;
"margin-left:1in;text-indent:-.25in;">(c)
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The risk aversion attitude of the market has shifted somewhat so
that the market risk premium is now 3% instead of 2%. (
"color:#00B0F0;">Km-Krf is now 3%)
Â
"MsoBodyTextIndent">Given that the current dividend, D0,
is $1.90 per share, determine the change in beta for your firm.
"text-decoration:underline;">
"color:rgb(0,176,240);text-decoration:underline;">Hints:
Use the
constant growth model.
Use the
CAPM.
Use BOTH
models TWICE.
ANSWER: New beta =
3.17
"background:#FFFF00;">How do I use the hints above to come to the
final answer of 3.17?
Explanation / Answer
Calculating Old Beta
As per DDM
price =D1/Re-g
Re = (1.90*1.05)/40 + 0.05 = 9.99%
As per CAPM
Re= Rf+(Rm-Rf)*Beta
Old Beta = (Re-Rf)/(Rm-Rf)
= (9.99-6)/2
=2
Calculating New Beta
As per DDM
Current price =D1/Re-g
Re = (1.90*1.105)/30 + 0.105 = 17.50%
As per CAPM
Re= Rf+(Rm-Rf)*Beta
New Beta = (Re-Rf)/(Rm-Rf)
=(17.50-8)/3
=3.17
Change in Beta in my firm is 2 to 3.17
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