The risk-free rate of return, rRF, is 11%; the required rate of return on the ma

Question

The risk-free rate of return, rRF, is 11%; the required rate of return on the market, rM, is 14%; and Schuler Company’s stock has a beta coefficient of 1.5.

a. If the dividend expected during the coming year, D1, is $2.25, and if g is a constant 5%, then at what price should Schuler's stock sell?

b. Now suppose that the federal Reserve Board increases the money supply, causing a fall in the risk-free rate to 9% and in rM to 12%. How would this affect the price of the stock?

c. In addition to the change in part b, suppose investors’ risk aversion declines; this fact, combined with the decline in rRF, cause rM to fall to 11%. At what price would Schuler’s stock now sell?

d. Suppose Schuler has a change in management. The new group institutes policies that increase the expected constant growth rate to 6%. Also, the new management stabilizes sales and profits and thus causes the beta coefficient 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 Schuler’s new equilibrium price? ( Note: D1 goes to $2.27)

Explanation / Answer

expected rate on return = 11% + (14%-11%) * 1.5 = 15.5 %

a) price of stock = 2.25 / (0.155 - 0.05) = 21.43

b)new rate of return = 9% + (12%-9%) * 1.5 = 13.5%

price of stock = 2.25/(0.135-0.05) = 26.47

price of stock is increased by 5.04

c)new rate of return = 9% + (11%-9%) * 1.5 = 12%

price of stock = 2.25/(0.12-0.05) = 32.14

d) new rate of return = 9% + (11%-9%) * 1.3 = 11.6%

price of stock = 2.25/(0.116-0.06) = 40.18

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