Question

Question 27.27. Mahlo is planing to diversify into the bakery industry. As a result, its beta should drop from 1.5 to 1.0 and the expected long-term growth rate of dividends will drop from 12% to 8%. The risk-free rate is 2%, the expected market risk premium is 10%, and the current dividend per share paid by Mahlo is $3.10. Should Mahlo complete the diversification into the bakery industry? (Points : 3.4)

       No, stock price drops about $6.20.
       Yes, stock price increases about $14.26.
       Yes, stock price increases about $15.50.
       Probably. The stock remains the same if it diversifies into the bakery industry.

Answer 1

Yes, stock price increases about $14.26.

This question will require use of CAPM and dividend discount model.

Based on CAPM Equation,

Expected Return on Stock = Risk free rate + Beta * Market Risk Premium

Based on Dividend Discount Model,

Now, before diversification,

Expected Return = 2% + 1.5 * 10% = 17%

D1 = 3.1 * (1 + 12%) = $3.472

V0 = 3.472/(17% - 12%) = $69.44

Now, after diversification,

Expected Return = 2% + 1.0 * 10% = 12%

D1 = 3.1 * (1 + 8%) = $3.348

V0 = 3.348/(12% - 8%) = $83.70

==> Value of share rises after diversification. Increase = $83.7 - $69.44 = $14.26