Company has a beta of 1.5 and 150,000 shares of stock outstanding. In Jan 2015 t

Question

Company has a beta of 1.5 and 150,000 shares of stock outstanding. In Jan 2015 the company forecasts revenues of $2 million for the year with fixed costs of 500,000 and variable costs of 25% of revenues. It pays 40% income tax. The risk free rate is 4% and market rate is 12%. (Company pays out all earnings as dividends and doesn't anticipate any growth).

1) Using the Capital Asset Pricing Model, what would you expect the equilibrium price of a share of the company stock to be, based upon the January forecast?

2) In March 2015, it issued a warning that due to the increasing cost of fuel, variable costs were going to be 40% of revenues instead of the previously forecasted variable cost of 25%. Also the company thought a growth rate of 5% in the future very likely. If everything else remain the same, using the Capital Asset Pricing Model, what would you expect the equilibrium price of a share of the company stock to be after this warning and grwoth rate update were issued?

Explanation / Answer

Cost of Equity (Ke) = Risk free rate + beta ( Market rate - Risk free rate)

= 4 + 1.5 ( 12 - 4)

= 4 + 12

= 16%

Calculation of earnings:-

Sales

(-) Variable costs (25 % of 2000000)

2000000

500000

Contribution

(-) Fixed Costs

1500000

500000

Earnings before taxes

(-) Taxes @ 40%

1000000

400000

As the company pays out all earnings as dividends, So the dividend amount = $ 600000

Dividend per share (DPS) = 600000 / 150000

Dividend per share (DPS) = 4

The equilibrium price of a share of the company stock = Dividend per share (DPS) / Cost of equity (Ke)

= 4 / 0.16

= $ 25

Conclusion:- 1) Using the Capital Asset Pricing Model, the equilibrium price of a share of the company stock would be expected to be $ 25 based upon the January forecast.

2)

Calculation of earnings:-

Sales

(-) Variable costs (40 % of 2000000)

2000000

800000

Contribution

(-) Fixed Costs

1200000

500000

Earnings before taxes

(-) Taxes @ 40%

700000

280000

As the company pays out all earnings as dividends, So the dividend amount = $ 420000

Dividend per share (DPS) = 420000 / 150000

Dividend per share (DPS) = 2.8

   Growth rate (G) = 5% (given)

   Expected Dividend (D1) = 2.8 + 5% = 2.94

Cost of equity (Ke) = 16 %

The equilibrium price of a share of the company stock = D1 / Ke - G

= 2.94 / 0.16 - 0.05

= 2.94 / 0.11

= $ 26.73 (approx)

Conclusion:- 2)  If everything else remain the same, using the Capital Asset Pricing Model, the equilibrium price of a share of the company stock would be expected to be $ 26.73 after this warning and growth rate update were issued.

Sales

(-) Variable costs (25 % of 2000000)

2000000

500000

Contribution

(-) Fixed Costs

1500000

500000

Earnings before taxes

(-) Taxes @ 40%

1000000

400000

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