Question

Your firm has a beta of 0.5 and just paid a dividend of $1.20 that is expected to grow at 4%. You are considering making an acquisition that would increase your growth rate to 6.5% and your beta to 0.8. If the risk-free rate is 2% and the market risk premium is 7%, should you make the acquisition?

A. Yes

B. No

Answer 1

The correct answer is Yes

Detailed Explanation Below:

Expeceted return = Risk free return + Beta ( Market return - Risk Free return)

= 2% + 0.50 * 7%

= 5.5%

Share Price = Dividend for next year / ( Expected return - Growth rate)

= 1.20 * ( 1 + 4%) / ( 5.5% - 4%)

= 1.248 / (1.5%)

= 83.2

Now, The Growth is Expected to rise by 6.5% and beta 0.80

Expected return = 2% + 0.80 * 7%

= 7.6%

Share Price = 1.20 * ( 1 + 4%) / ( 7.6% - 6.5%)

= 1.248 / (0.9%)

= 138.66

The share price has increased so we should consider the acquisition as it shows that the Value of shareholder is getting maximised.