Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of $20.00.Carlson's next dividend, , is forecasted to be $2.00, and Carlson is growing at an annual rate of 6 percent.Carlson has a beta coefficient of 1.2, and the required rate of return on the market is 15 percent.As Carlson's financial manager, you have access to insider information concerning a switch in product lines which would not change the growth rate, but would cut Carlson's beta coefficient in half.If you buy the stock at the current market price, what is your expected percentage capital gain?
A) 23%
B) 33%
C) 43%
D) 53%
E) There would be a capital loss.

Question

Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of $20.00.Carlson's next dividend,  , is forecasted to be $2.00, and Carlson is growing at an annual rate of 6 percent.Carlson has a beta coefficient of 1.2, and the required rate of return on the market is 15 percent.As Carlson's financial manager, you have access to insider information concerning a switch in product lines which would not change the growth rate, but would cut Carlson's beta coefficient in half.If you buy the stock at the current market price, what is your expected percentage capital gain?
A) 23% 
B) 33% 
C) 43% 
D) 53% 
E) There would be a capital loss.

Quizplus · Accepted Answer

First, we need to calculate the required rate of return on Carlson's stock using the Capital Asset Pricing Model (CAPM):

Required rate of return = Risk-free rate + Beta coefficient * (Market rate of return - Risk-free rate)
Required rate of return = 0.06 + 1.2 * (0.15 - 0.06) = 0.198 = 19.8%

Next, we can calculate the expected dividend yield:
Expected dividend yield = Next dividend / Current market price = $2.00 / $20.00 = 0.1 = 10%

Finally, we can calculate the expected capital gain:
Expected capital gain = Expected growth rate + Expected change in valuation multiple - Expected dividend yield
Expected growth rate = 6%
Expected dividend yield = 10%
Expected change in valuation multiple = (New beta / Old beta) - 1 = (0.6 / 1.2) - 1 = -0.5 = -50%
Expected capital gain = 6% - 50% - 10% = -54%
Since the expected capital gain is negative, there would actually be a capital loss if the switch in product lines occurs. Therefore, none of the answer choices are correct.

Carlson Products, a Constant Growth Company, Has a Current Market