Micromatic is considering expanding into a new product area. Micromatic\'s curre
ID: 2758275 • Letter: M
Question
Micromatic is considering expanding into a new product area. Micromatic's current beta is 1.2 and its beta is expected to increase to 1.45 after the expansion. The long-term growth rate of the firm's earnings is expected to increase from 6.5 percent to 10 percent. Micromatic's current dividend is $1.70 per share, the current risk-free rate is 9.1 percent, and the expected market return is 12.9 percent. Should Micromatic undertake the planned expansion?
A) Yes, stock price increases $0.45
B) No, stock price decreases $15.27
C) Yes, stock price increases $15.27
D) No, stock price decreases $10.15
Explanation / Answer
Current position:
Required return (CAPM) = Rf+×Rp
Rf is risk free return
Rp is risk premium
= 9.1%+1.2×(12.9%-9.1%)
= 13.66%
Stock price, P0 = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
= $1.70×(1+6.5%)÷(13.66%-6.5%)
= $25.29
New position:
Required return (CAPM) = Rf+×Rp
Rf is risk free return
Rp is risk premium
= 9.1%+1.45×(12.9%-9.1%)
= 14.61%
Stock price, P0 = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
= $1.70×(1+10%)÷(14.61%-10%)
= $40.56
Share price increased by $15.27 ($40.56-$25.29)
Option C is correct.