Question

Products San Osvaldo, a company with constant growth, has a current market price of $ 20.00. The next expected dividend (D1) is forecast at $ 2.00, and San Osvaldo grows at a rate of 6% per year. The company has a beta of 1.2, and the required return from the market is 15%. As Chief Financial Officer, you have access to internal information regarding a change in product lines that you hope will not affect growth but will affect the company's beta, halving it. If you buy stocks at the current market price, how much percentage return on capital gains would you expect?

Answer 1

D1 =2
Price in year 0 =20
Growth=6%
Required rate of stock =D1/P0+g =2/20+6% =16%

Required rate of return as per beta and CAPM formula =Risk free Rate+Beta*(Market Return-Risk free Rate)
16% =Risk free Rate+1.2*(15%-Risk free)
Risk free Rate =(1.2*15%-16%)/(1.2-1) =10%


New Beta after change in product line =1.2/2 =0.6
Required rate of return as per new beta and CAPM formula =Risk free Rate+Beta*(Market Return-Risk free Rate)
=10%+0.6*(15%-10%) =13%
New Price of stock =D1/(Required Rate-growth) =2/(13%-6%) =28.57

Capital Gain =(New Price of Stock-Old Price of Stock)/Old Price of Stock =(28.57-20)/20 =42.86%