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% to 10%. Micromatic's current dividend is $1.70 per share, the current risk-free rate is 9.1%, and the expected market return is 12.9%. Should Micromatic undertake the planned expansion?
A) No, stock price decreases $10.15.
B) Yes, stock price increases $15.27.
C) Yes, stock price increases $0.45.
D) No, stock price decreases $15.27.

Question

Quizplus · Accepted Answer

To determine if Micromatic should undertake the expansion, we need to calculate the new required rate of return using the capital asset pricing model (CAPM):
Expected Return = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate)
Current expected return = 9.1% + 1.2 * (12.9% - 9.1%) = 13.94%
New expected return = 9.1% + 1.45 * (12.9% - 9.1%) = 15.36%
Next, we can calculate the new expected dividend using the expected long-term growth rate:
New Dividend = Current Dividend * (1 + Long-Term Growth Rate) = $1.70 * (1 + 10%) = $1.87
Finally, we can use the Gordon growth model to calculate the stock price after the expansion:
Stock Price = New Dividend / (Required Rate of Return - Long-Term Growth Rate)
Current stock price = $1.70 / (0.1394 - 0.065) = $22.44
New stock price = $1.87 / (0.1536 - 0.10) = $38.71
Therefore, the stock price increases by $16.27 ($38.71 - $22.44), and the correct answer is B.

Micromatic Is Considering Expanding into a New Product Area