304 Part 3 Financial Assets
EQUILIBRIUM STOCK PRICE The risk-free rate of return, rRF, is 6%; the required rate of
return on the market, rM, is 10%; and Upton Company’s stock has a beta coefficient of 1.5.
a. If the dividend expected during the coming year, D 1 , is $2.25 and if g " a constant 5%,
at what price should Upton’s stock sell?
b. Now suppose the Federal Reserve Board increases the money supply, causing the
risk-free rate to drop to 5% and rM to fall to 9%. What would happen to Upton’s price?
c. In addition to the change in Part b, suppose investors’ risk aversion declines and this,
combined with the decline in rRF, causes rM to fall to 8%. Now what is Upton’s price?
d. Suppose Upton has a change in management. The new group institutes policies that
increase the expected constant growth rate from 5% to 6%. Also, the new management
smoothes out fluctuations in sales and profits, causing beta to decline from 1.5 to 1.3.
Assume that rRF and rM are equal to the values in Part c. After all these changes, what
is its new equilibrium price? (Note: D 1 is now $2.27.)
BETA COEFFICIENTS Suppose Chance Chemical Company’s management conducted a
study and concluded that if it expands its consumer products division (which is less risky
than its primary business, industrial chemicals), its beta will decline from 1.2 to 0.9.
However, consumer products have a somewhat lower profit margin, and this would
cause its constant growth rate in earnings and dividends to fall from 6% to 4%. The
following also apply: rM " 9%, rRF " 6%, and D 0 " $2.00.
a. Should management expand the consumer products division? Explain.
b. Assume all the facts given except the change in the beta coefficient. How low would
the beta have to fall to cause the expansion to be a good one? (Hint: Set Pˆ 0 under the
new policy equal to Pˆ 0 under the old one and find the new beta that will produce this
equality.)