HDTV has planned on diversifying into the VR field. As a result, HDTV's beta would rise to 1.6 from 1.2 and the expected future long-term growth rate in the firm's earnings would increase from 12% to 16%. The expected market return, k_m, is 14%; the risk-free rate, r_f, is 7%; and the current dividend, D_o, is $0.50. Should HDTV go into the VR field? A) No, stock price decreases $7.82. B) Yes, stock price increases $9.89. C) Yes, stock price increases $3.81. D) No, stock price decreases $3.78.

Question

Quizplus · Accepted Answer

First, we need to calculate the required rate of return for HDTV using CAPM:

kS1U1B1mS1U1B0 = rS1U1B1fS1U1B0 + (kS1U1B1mS1U1B1 - rS1U1B1fS1U1B0) * beta

kS1U1B1mS1U1B0 = 0.07 + (0.16 - 0.07) * 1.6
kS1U1B1mS1U1B0 = 0.19 or 19%

Next, we can calculate the expected value of HDTV's future dividends using the Gordon growth model:

kS1U1B1mS1U1B0 = (D1 / P0) + g
0.19 = ($0.50 / P0) + 0.12
P0 = $4.76

This is the current stock price for HDTV. Now, we can calculate the new stock price if HDTV enters the VR field:

kS1U1B1mS1U1B0 = rS1U1B1fS1U1B0 + (kS1U1B1mS1U1B1 - rS1U1B1fS1U1B0) * beta
0.19 = 0.07 + (0.16 - 0.07) * 1.2
kS1U1B1mS1U1B0 = 0.16 or 16%

kS1U1B1mS1U1B0 = (D1 / P0) + g
0.16 = ($0.50 / P1) + 0.16
P1 = $5.50

The new stock price with VR diversification is $5.50, which represents an increase of $0.74 from the current stock price of $4.76. Therefore, the answer is B, HDTV should go into the VR field because the stock price is expected to increase by $0.74 or 15.55%.

HDTV Has Planned on Diversifying into the VR Field