In March 2015, the Value Line Investment Survey reported the following market be

Question

In March 2015, the Value Line Investment Survey reported the following market betas for W$D, HLA, United Pharma, and Great Reasonable Efficient and Effervescent Drug, Inc:      

Company

Beta

Healthy Lives for All

0.9

We$ellDrugs

1.2

Great Reasonable Efficient and Effervescent Drug

1.5

United Pharma

1.7

Risk free rate

6.50%

Required rate of return on market

13.50%

At the time these betas were developed, reasonable estimates for the risk-free rate, RF, and the required rate of return on the market, R(Rm), were 6.5 percent and 13.5 percent, respectively.

a. Using the SML/CAPM model what are the required rates of return on the four stocks?   

b. Why do their required rates of return differ?                                                              

c. If the outcome of the congressional hearings into W$D pricing yields regulated prices what do you expect would happen to W$D’s stock price? Why?

d. If reulated prices were binding for 10 years, what would you expect to happen to W$D’s beta? Why? (Hint: Why do estimates of a firms future earnings vary?)

Company

Beta

Healthy Lives for All

0.9

We$ellDrugs

1.2

Great Reasonable Efficient and Effervescent Drug

1.5

United Pharma

1.7

Risk free rate

6.50%

Required rate of return on market

13.50%

Explanation / Answer

Part- A

Using the CAPM Re = RFR + Beta*(RM-RFR) where Re is the required rate of return, RM is the market risk and PFR is the risk free rate, Beta is the measure of systematic risk.

Healthy Lives for ALL: Re = 0.065 + 0.9*(0.135-0.065) = 0.128 = 12.8%

We$ell Drugs: Re = 0.065 + 1.2*(0.135-0.065) = 0.149 =14.9%

Great Reasonable Efficient and Effervescent Drug: Re =  0.065 + 1.5*(0.135-0.065) =0.17 = 17%

United Pharma: Re =  0.065 + 1.7*(0.135-0.065) = 0.184 =18.4%

Part- B

The rates differ beacuse of different beta. Each stock has its own measure of risk and hence the returns vary.

Part-C

The the congressional hearings result in regulated prices, the earnings of the company will reduce and this will send a negative signal and hence the stock price will fall.

Part -D

If the prices were regulated for 10 years, there is a clear value to the earnings of the compnay. This means that the stock will fall immediately and adust itself to the lower earnings. On the long term, since the prices are regulated,the price of the stock will gradually rise.

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